There is nothing like a sudden drop in the share market to send investors into a panic. It is easy at the time of investing to be full of confidence and classify yourself as someone willing to take risk in exchange for the potential of a higher return. However, when volatility strikes, confidence can quickly be eroded. Volatility quickly sorts out those investors who truly understand their tolerance and capacity for risk and those who don’t.
The principal risk management tool for share market investors is diversification. For small investment amounts, diversification can be achieved through investing in a fund. Investors who choose to ignore the principle of diversification are in effect speculators rather than investors, believing they can pick winners and taking on higher risk for the chance of higher returns. A diversified portfolio of shares will mimic the behaviour of the market as a whole, reaching neither infinity nor zero in value, but moving above and below a market trend line. The key risk for diversified investors becomes one of how long funds need to remain invested in order for the market to return to trend. A loss will only be crystallised if investments are sold before this happens. This is where the concept of risk capacity becomes important; that is, the ability to absorb loss without significant impact on your overall financial situation. Investors with a short investment time frame or a low level of wealth or income are more likely to have a low capacity for risk.
The key to being a successful investor is to learn to overcome the emotions of fear and greed and make sound investment decisions based on objective analysis and a long term strategy. Investors should pay little heed to news headlines, which are designed to sell newspapers, not provide investment advice.