Oct 24, 2022 - Risk, Liquidity, Volatility, and Tolerance: Four Key Terms to Know
Educating yourself about investing and personal finance often involves learning a whole new vocabulary. Risk, volatility, tolerance, liquidity—you might know these terms from other contexts, and you might even have an idea of what they mean in the investing world, but if you’re like a lot of individual investors, you might not have a clear idea of how they all impact each other in your portfolio.
In this blog post, we’re going to change that. When it comes to investing, knowledge is power. And by having a clear understanding of how all of the cogs in your strategy drive and turn each other, you’re empowered to make wiser decisions regarding your unique financial outlook.
Risk: It’s Personal
In finance, risk refers to the possibility of losing some or all of an investment.
The greater the possibility of losing your investment, the riskier that investment is said to be. For example, cryptocurrency is a risky investment. It’s relatively new, it’s not backed by anything, and every day, each individual coin’s value can fluctuate wildly. In contrast, government bonds are a low-risk investment because they’re backed by the US government.
That doesn’t make US bonds a “better” investment than cryptocurrency. They’re a great option if reliability is more important to you than growth…but if you’re looking to invest in something that will yield high returns, US bonds aren’t the best choice. Generally speaking, higher risk is correlated with a higher potential return. To develop an appropriate strategy for your portfolio, think critically about how much you need your portfolio’s value to grow versus how much you need to insulate against losses.
When you think about risk, think about it in terms of what you can personally afford to lose. Of course, nobody wants to lose any of the money they invest…but the only way to guarantee that is to not invest at all. You’re probably familiar with the term risk tolerance. This is how much an individual portfolio can afford to lose in the event of a market downturn or an asset’s value bottoming out.
Your risk tolerance is unique to you. For example, a younger investor who has no dependents generally has a higher risk tolerance than an older investor who’s actively planning for their children’s college expenses, since that younger investor doesn’t need to come up with a specific amount of cash by a certain date.
Liquidity: Your Emergency Stash
One of our favorite phrases is this: “every crisis is a crisis of liquidity.” What this means is that when you’re in a crisis, like facing the aftermath of a serious car accident or suddenly needing to sell your home and move, you need cash on hand. How easily you can get cash into your hands is referred to as liquidity.
Money in a checking account is liquid—you can go to the ATM and take it out in just a minute or two. Your equity in your home isn’t liquid—if you need to access that money, you need to go through the lengthy process of listing and selling your home, which can take months and involves costs like the agent’s commission and closing costs.
Keep your liquidity needs in mind as you determine your ideal investing strategy. How much money do you need to cover your living expenses in the event you can’t work? Are you comfortable with having six months covered, or would you feel more secure with a year’s worth of expenses covered? An accessible, liquid amount of cash is an important component of any financial portfolio.
Volatility: There’s No Avoiding it
Volatility is the rate at which a stock’s price goes up or down during a specific period of time. Volatility is a normal, expected part of participating in the stock market. Some stocks are more volatile than others—in other words, some fluctuate within a wider range, while others generally go up or down in value just a little bit, not making a huge difference to your portfolio’s overall value.
Day traders capitalize on volatility. Set-it-and-forget-it investors tend to largely steer clear of it. As you balance pursuing potential gains against insulating yourself from potential losses, consider the historic volatility of the securities you choose. More volatile assets can net you huge gains…but they can also drop you in some deep holes.
Work with an Experienced Wealth Advisor
Your needs are unique. So are your goals. As a team of holistic wealth advisors, we recognize that the ideal strategy for your portfolio looks very different from the ideal strategies for many of our other clients’ portfolios. To learn more about the approach we would take to optimize your unique portfolio, contact Sax Wealth Advisors today to schedule your consultation with a member of our firm.