Risk Tolerance – Part 2 (Calculation)

In this video we continue to talk about Risk Tolerance!

VIDEO SUMMARY

In this video we are going to continue talking about risk tolerance. In the last video we talked about the concept of risk tolerance and how it is all about understanding your situation. What I want to do in this video is to actually perform some calculations. The benefit of performing calculations is it puts numbers on paper. It really gives you a better understanding when you see these hard numbers of what your situation is. The problem is a lot of people think that they can handle riskier investments than their level of risk tolerance actually warrants. They will think, “Hey I can handle taking out higher levels of risk because I want to get that higher level of reward.” But when you look at the hard numbers you might get a better understanding of your situation. Your goal should be to make decisions that are more aligned with your goals and your current situation.

So let us jump right into this. One of the key things to understand is your savings rate. How much money, or what percentage of your monthly income, are you putting into savings every month? Let us say you had a really large income. Let us say you had 100k a month coming in and you had a savings rate of ten percent. Well that means that you would be saving 10k a month. Now that is important to understand because that is money that you are getting every month that you are looking to put to work for you in some form of investment. That also means that if you have investments out there already, let us say investments with 30k at risk, well if you lost that 30k, now that you know your savings rate, you now understand it is going to take you three months to pay back the money that you lost. So when you put these numbers down you are really starting to understand your situation. How much money you are saving a month and how long it will take you to pay off any money that is lost. The key point is understanding how much money you are willing to lose.

Let us take this a step further and look at the investment. Let us say you are investing at a risk level of around twenty percent. That is a high level of risk. Let us say you found ten different stocks. And these ten different company stocks are exciting stocks. You are excited about them. So you do your calculations and your assumption is that they are at twenty percent risk. Let us say you have a hundred and fifty thousand dollars spread out across these investments. What I want you to understand is what twenty percent risk actually means. Twenty percent risk means that you are assuming that twenty percent of the time you are not going to get your money back. So you have ten companies at twenty percent risk. You are assuming two of those companies are going bankrupt or experience some other financial uncertainty and you are not getting any return on investment. And that might make sense because you have eighty percent where you are expecting to make your investment. This is what I want you to understand is twenty percent is at risk here. Now I said before you invested 150k across these ten companies, so twenty percent of 150k is 30k. So you have 30k at risk. Now let us tie this back to the situation we discussed earlier. If you are saving 10k a month and 30k is at risk, if you lose that, like you are assuming you are going to lose it, then it is going to take you three months to pay that back. You have to decide if that is really appropriate with the level of risk tolerance that you want.

Now I want to take it even a step further because, you have to understand, these are all assumptions. These are your assumptions on what you think is going to happen in the future. So you might not have two companies that go bankrupt. You might have no companies go bankrupt. You might have more than two companies go bankrupt. You might have four companies go bankrupt. If that happens, you would not lose just 30k, you would lose 60k. And instead of three months to pay that back, it would take you six months to pay that back. Do you see how that works? So these are just assumptions and there are going to be variations from your assumptions into what actually happens. So you have to be prepared for that.

Let us look at a slightly different example, and let us lower the risk factor from twenty percent to ten percent. Let us say you looked at this scenario. You thought maybe this might be a little bit risky. You might not want to even be close to the scenario where four companies could go bankrupt. That is a lot of money at risk. If you decrease it and look for securities that are around ten percent risk, that means at 150k for ten investments, only 15k is at risk. That is half of what was at risk before. If I lose 15k, like you are assuming, it is only going to take a month and a half to pay back. Hopefully the other ninety percent of the investments turn out as planned. If that 15k increases, like it can because these are all just assumptions, let us say the 15k increases to 30k, well then it would take three months to pay it back. So I hope you start to see when you actually run through these calculations and run through these scenarios what it is doing. It is giving you an understanding. It shows you what your real situation is, and what you feel comfortable with. It shows you what level of risk is right for your situation and your goals. Here is the key takeaway. Be aware of the riskiness of your investments and then tie that riskiness to the riskiness of your financial position and see if your investments make sense.