Understanding investment risk and your personal risk tolerance is key to successful investing. Today we’ll visit both of those items to help you make intelligent investment decisions that are best for you.

Investing for beginners: Investment Risk

Investing Risk

The risk factors of investing are very often misunderstood.

Consider this situation to highlight how most people think of risk: Warren Buffett’s net worth dropped over $20 billion dollars through the Great Recession.

Question: How much money did Warren Buffett lose during the Great Recession?

Answer: He didn’t lose any money because he didn’t sell. Today his net worth is much higher than it was before the start of the Great Recession.

Market Swings: Volatility

What many people consider the biggest risk of investing is actually volatility. Volatility is when markets move – up or down. And that happens all the time.

A market correction is defined by the value of the stocks as a whole drop 10% or more from a recent peak. This happens every 3-5 years on average. It’s a normal occurrence that anyone interested in investing should understand.

If you have a long investing timeline – say 20 years or more – you shouldn’t care about volatility. Actually, that’s not quite right. You should care. You should care because if you are investing consistently, every time market prices drop you get to buy your shares at a discount!

Market Risk

On the other hand, if your investing timeline is shorter, then market volatility does turn into a risk factor.

The average market correction lasts less than two years. A couple of corrections in the past have lasted longer though. That’s the danger of just considering averages. If you are retiring within a couple of years and the market drops by 30%, it could impact your retirement goal. That’s why most financial advisors recommend clients consider shifting some money into less-volatile bonds as they get closer to retirement.

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Purchasing Power Risk

Perhaps the second most important risk factor to consider, yet often ignored, is purchasing power risk. This is more commonly just referred to as inflation.

The United States has seen historic inflation rates average between 2 and 3% annually. That means that every year – on average – prices increase by 2-3%. If you are not investing, but instead have your money in a bank savings account, you are effectively losing money.

Because of inflation, your $1,000 today might only purchase $750 worth of goods in the future. Along the same lines, a household budget of $50,000 today might cost $75,000 by the time you retire. That needs to be considered in your investment planning. Ignoring this risk can derail your big financial goals.

Your Risk Tolerance

There are a number of factors to consider when thinking about your own investing risk tolerance. A good place to start is to ask yourself some questions. Vanguard has a questionnaire with some great thought-provoking questions – I’ll quote a couple of them here:

“From September 2008 through November 2008, stocks lost over 31%. If I owned a stock investment that lost about 31% in 3 months, I would: (If you owned stocks during this period, select the answer that corresponds to your actual behavior.)”

And a similar question of…

“From September 2008 through October 2008, bonds lost nearly 4%. If I owned a bond investment that lost almost 4% in 2 months, I would:(If you owned bonds during this period, select the answer that corresponds to your actual behavior.)”

The answers include sell everything, sell some of the investments, do nothing, or buy more. Selling – unless you had a critical need for the money – would, of course, be a low-tolerance answer. The “best” answer would be to do nothing – stick with the plan unless you actually need the money right away.

Addressing the #1 concern people have about inv