How Much Risk Should You Actually Take With Your Investments?

Often times, when people hear the word risk in investing, they usually think about losing money. But investment risk is way more complicated than that. There is the risk that an investment falls in value, the risk that inflation eats away at your purchasing power, and even the risk of being too conservative and missing years of potential growth. However, we need to find the right balance for your specific goals and also how long you plan to invest for. 

A 20-year-old and a 60-year-old shouldn't necessarily invest the same way. A young investor has something extremely valuable: time. If the market falls when you're young, you potentially have decades for your investments to recover and continue growing. Someone who needs their money next year doesn't have that luxury. For a 60-year-old planning to retire in 5 years, a good portion of their investment must have lower-risk, such as bonds. This doesn't mean the 20-year-old should just risk everything because they have more time, but instead to have majority in index funds and not so much bonds.

Before you decide how much risk to take, figure out what the money is actually for. Money you might need for a car, college expenses, or a house in the next few years generally shouldn't be treated the same as money you're investing for retirement decades from now. If you will need to have this money in the next 10 years compared to 40 years, the strategies behind those goals must reflect that. The longer your time horizon, the more opportunity you have to ride out short-term market declines. 

Risk Tolerance vs. Risk Capacity

Two people can have the same financial situation but completely different reactions to a market crash. Risk tolerance is how comfortable you are watching your investments fall. Risk capacity is how much loss you can actually afford to withstand financially. Someone might be emotionally comfortable with a 40% decline but unable to afford it because they need the money soon. If you are playing the long game and plan to have the money waiting for another 30+ years, than you need to understand that there will be periods of time where you are 'losing' money.

But this is easier said than done, which is why I will give this example. Imagine you have $10,000 invested and the market falls a whopping 30%. Your account now shows roughly $7,000. Nothing about the number on the screen feels good, but the bigger question is what you would actually do next. Would you panic and sell? Would you stop contributing? Or would you understand that market declines are part of investing and stay with your plan? Be completely honest with yourself, because like I have said before, this will most likely occur at some point, even if it isn't as extreme.

Remember, being young doesn't give you permission to gamble. Being young gives you a longer time horizon, but it doesn't mean you should blindly choose the riskiest investment available. Individual stocks, highly speculative assets, and other concentrated investments can experience enormous losses. A smarter, safer, young investor can pursue long-term growth while still using diversification to avoid depending on one company or one investment succeeding.

Now we arrive at a crucial point, which is diversification. Owning one company is very different from owning hundreds or thousands of companies through a diversified index fund. If one company struggles, a diversified portfolio isn't necessarily devastated because other businesses are still operating and growing. Diversification doesn't eliminate the possibility of losing money, but it can reduce the damage caused by any single investment failing. Having international and domestic index funds doesn't guarantee losses, but helps you eliminate unnecessary, concentrated risk.

One big mistake that I feel is quite common is that your emergency fund shouldn't be in the stock market! One of the easiest ways to accidentally take too much investment risk is to invest money that you actually need for emergencies. If your car breaks down or you suddenly lose your income, you don't want to be forced to sell investments during a market crash just to pay the darn bills. Keeping an appropriate cash reserve can allow your long-term investments to stay invested when the market is having a bad year. 3 months of expenses saved in a seperate emergency fund is a good rule of thumb, at least for many people.

For me the single biggest mistake a young investor could make is not doing anything, even after you read this article. There is a temptation to wait until you have more money, more knowledge, or the "perfect" market conditions before investing. But there is also a cost to waiting. A young investor has decades for compound growth to work, and missing those early years can be difficult to make up later, even if you didn't invest a lot before.

The best investment strategy isn't necessarily the one with the highest possible return. It's the one that gives you a reasonable opportunity for long-term growth while allowing you to stay invested when things get uncomfortable. For a young investor with a long time horizon, that may mean accepting significant short-term market volatility in exchange for long-term growth potential. The important thing is to understand why you're taking that risk before the market falls—not trying to figure it out after it does.