How to Tell If You’re Ready for a High-Risk/High-Reward Investment

Ask yourself this: Can I afford to lose it all? If not, then you have a little work to do first.

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(Image credit: Getty Images)

There are no shortcuts when it comes to building wealth. Achieving your financial goals requires careful planning, dedication and hard work.

Investments with high reward potential also have a much higher risk. Whether it’s a business venture, an IPO, an option or an ETF for an emerging market, there are plenty of investment vehicles to consider if you’re willing to take the risk to seek a high reward.

But what happens if this investment goes south? Would you lose money that you need to cover daily expenses, housing or retirement? If the answer is yes, you’re not quite ready for these types of risky investments. (opens in new tab)

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First, Build a Safety Net

Before you can think about adding risky investments to your portfolio, you need to build a safety net to help absorb losses. With enough money put aside to cover your expenses and retire comfortably, only then can you afford to allocate capital to different investment vehicles, staying financially stable even if you lose the investments. Of course, this pertains more to risky investments rather than safe investments, such as starting a business or trading in penny stocks.

According to Fidelity, a person who saves for their retirement between the ages of 25 and 67 should put aside 15% of their pretax income (opens in new tab). It’s a good rule of thumb for achieving financial stability. How much a person should have saved before engaging in risky investments does vary. In general, it’s best to take investment risk after you have enough saved for your life’s everyday wants and needs.

There are a variety of products to consider when building a safety net, including savings accounts, insured money market accounts and certificates of deposit with a guaranteed rate of return. These products don’t yield high payoffs due to their low rates, but FDIC insurance makes them safe, and the money remains easily accessible in case of an emergency.

Having a High Income Doesn’t Mean You Can Afford to Take Risk

A high risk tolerance means that an investor can lose their initial investment and remain financially stable. It’s important to understand that income is not what determines risk tolerance.

Risk tolerance varies from one individual to another and doesn’t necessarily depend on earning potential. According to Forbes, 66% of young adults (opens in new tab) between the ages of 18 and 29 feel that the stock market is scary or intimidating. This percentage drops to 57% for the 55-and-older age group. This change in attitude can be interpreted as an increased risk tolerance. As someone ages and builds wealth, volatile investments seem less intimidating since these investors can stomach the loss.

For instance, a doctor with a high earning potential might have a low risk tolerance because of debt and other factors. According to the Association of American Medical Colleges, medical school students graduate with an average of $201,490 in debt (opens in new tab). A young professional in the medical field might want to take a risk and invest in a promising business venture, however they probably shouldn’t. If this high-risk investment doesn’t pan out, keeping up with hefty student loan payments could become challenging.

On the other hand, a couple who lives within their means for 20 years and works hard to save up $200,000 can afford to take risk. The couple might increase their wealth by investing in a promising business venture, but if they sustain a loss, it won’t affect their standard of living or threaten their financial situation.

Taking high risks without assessing risk tolerance rarely yields a positive outcome. To go back to the example of the doctor; this investor should take the time to save enough money to build a safety net, pay off student debt and then consider opportunities, like investing in business ventures to build wealth.

What Does Taking a Calculated Risk Mean?

Now, say you’ve done the hard work of saving up enough for a robust safety net and you’re feeling ready to take on some investing risk in pursuit of greater returns. While it's true that greater risks come with greater rewards, you must remember that risky decisions in themselves don’t yield rewards. The real payoff comes once investors assess their risk tolerance and take calculated risks.

Investors should consider the current performance and volatility of their portfolio before deciding to add a new investment vehicle. They should consider the likelihood that this new investment won’t perform as expected, as well as the margin by which it could miss the targeted return. This should all be considered in conjunction with how much savings the investor has gathered.

Oftentimes, we’ll run financial plans and a client will have a play account on the side. As long as the plan works, the client has the control to do whatever they’d like with this account, whether a crazy investment or buying a boom-or-bust piece of real estate.

The bottom line

Rather than depending on risk to build wealth fast, prioritize working hard and persistently saving. When an investor has a safety net prepared, they can have peace of mind knowing they’ll have savings to fall back on if an investment doesn’t go as planned.

Although high-risk investments can offer substantial returns, smart investors will take the time to lay a financially stable foundation before considering them. Their diligent efforts will pay off in the form of a portfolio that can absorb a loss if an investment doesn’t pan out.

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

Andrew Rosen, CFP®, CEP
President, Partner and Financial Adviser, Diversified, LLC

In March 2010, Andrew Rosen joined Diversified (opens in new tab), bringing with him nine years of financial industry experience.  As a financial planner, Andrew forges lifelong relationships with clients, coaching them through all stages of life. He has obtained his Series 6, 7 and 63, along with property/casualty and health/life insurance licenses.