Whether you’ve decided to put it away, either for a rainy day or for some future need, such as your child’s tertiary education or to boost your retirement savings. When it comes to Investment management spread the risk. Here’s why.
Spreading your risk around, even if it’s all high risk, decreases your overall exposure to any single investment or trade. With appropriate diversification, the probability of total loss is greatly reduced. This comes back to preservation of capital.
That would be considered your risk Capital, which is your Net worth and available risk capital should be important consideration when determining risk tolerance. Net worth is simply your assets minus your liabilities. Risk capital is money available to invest or trade that will not affect your lifestyle if lost. It should be defined as liquid capital, or capital that can easily be converted into cash.
Therefore, an investor or trader with a high net worth can assume more risk. The smaller the percentage of your overall net worth the investment or trade makes up, the more aggressive the risk tolerance can be.
Unfortunately, those with little to no net worth or with limited risk capital are often drawn to riskier investments like futures or options because of the lure of quick, easy and large profits. The problem with this is when too much risk is assumed with too little capital, a trader can be forced out of a position too early.
On the other hand, if an undercapitalised trader using limited or defined risk instruments (such as long options) goes bust, it may not take that trader long to recover. Contrast this with the high-net-worth trader who puts everything into one risky trade and loses it will take this trader much longer to recover.