How to Invest: 5 Rules to Follow When Considering Risky Investments

The attraction of risky investments is a tale as old as time. Everyone wants to grow and expand their wealth, preferably as quickly and painlessly as possible. However, the greater the potential rewards at the end of the rainbow, the higher the probability for large-scale losses.

Make sure to consider the following five rules before you place your monies into more risky assets.

Know Your Risk Profile

Understanding your risk profile is paramount when deciding whether to make aggressive moves with your portfolio.

Beyond how you might personally feel when confronted with a loss of capital, it is essential to consider how this might impact both your day-to-day activities and your ability to achieve the goals that you have established for yourself down the road.

A willingness and capacity to absorb loss is part of the equation, but so is the idea that there will be future opportunities to rebuild your savings. The timeframes for aggressive investors should therefore be longer in nature, as the ability to recoup losses becomes more and more difficult the older you get.

For this reason, risk profiles tend to shift as individuals get closer to their retirement age and the number of working and earning years decreases. Investment horizons become shorter, by definition, later in life, as the fear of losing retirement savings starts to take precedence over the prospect of an uncertain windfall sometime in the future.

Understand Your Investments

Risky investments often offer something new and innovative, which has not been tried before. Packaged in shiny language and exciting graphs meant to attract investment dollars, they can be difficult to fully understand.

This holds true for legitimate companies pioneering promising new technologies and experienced financial managers who have designed intricately constructed investment vehicles. However, complexity can also serve fraudsters engaged in outright scams, who camouflage their deception with confusing jargon and terminology.

It is easy to grasp how a savings account or well-established company makes money, and how it will help grow your wealth. Something new and exciting may not be as straightforward to understand. If you are unsure how the investment you are considering will turn a profit, it is probably a good idea to avoid it.

Diversify Your Portfolio

Against a backdrop of uncertainty, diversification becomes all the more important. The principle of diversification will allow you to spread out both risk and reward, potentially even hedging your portfolio by investing in two different stocks or asset classes which tend to move in opposite directions.

Putting all of your investments into one stock can expose you to significant losses if the company makes poor business decisions or has a string of bad luck. The same is true for investing in a single industry, as market changes could cause all the stocks from a particular sector to tank.

Diversifying between both aggressive and conservative investments could also make sense. If you are committed to pursuing aggressive growth, think about setting aside a certain percentage of your portfolio for less riskier pursuits. If you place the bulk of your monies in bonds and large-cap, dividend-paying stocks, this will allow you to be less cautious with a smaller portion of your portfolio. Even if these riskier assets do not pan out, the rest of your portfolio should help you stabilize your overall investment holdings.

Accept an Active Management Style

Because they have the potential to change so frequently, aggressive investments generally go hand-in-hand with an active management style.

Due to the inherent uncertainty, developments in the market can have undue influence on these types of investments. Unlike a savings account which is guaranteed to return a predetermined level of interest, the performance of stocks, commodities, and real estate can turn when new information becomes available to investors.

For this reason, there will likely be a need to make adjustments to your portfolio on a fairly consistent and ongoing basis. This can be done individually if you are managing your portfolio, though often times it is the responsibility of a professional money manager. This adds another wrinkle of expense–either in time or in management fees–and is a factor that should be considered when thinking about adopting an aggressive approach with your money.

Become Comfortable With the Idea of Loss

Investing risk–like every type of risk–is the reliance on future developments that are not entirely under your control. Your investments could experience wild growth, but they could also plummet.

A good operating rule is to avoid risking monies that you cannot afford to lose. This is intrinsically connected to your aforementioned risk profile, but requires internalizing the fact that your investments may not pan out.

If your material existence will be directly harmed by losses in your portfolio, think extremely carefully about whether or not a risky approach makes sense for you. The very last thing you want to do is be wracked with worry over your investments. In other words, make sure you are comfortable with the assets in your portfolio.

Conclusion: A Risk-Based Approach

Risky investments certainly have their upsides, though they should be evaluated through a lens of potential losses in addition to the hoped-for rewards.

It is important for those considering risky investments to fully understand the assets in question, while also keeping active tabs on how they are performing. A well-balanced portfolio can also guard against severe losses, making the always wise move towards diversification even more prudent for those holding aggressive portfolios.

The trade-off between risk versus rewards is ever-present. Make sure you are focusing on both when making investment choices.

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