Risk capital plays a critical role in personal investing. Knowing how to identify and put yours to work is one of the key lessons in managing any portfolio. For investors looking to improve their strategies, here’s a quick breakdown.
What is it?
Risk capital is the section of your portfolio used for speculation. It’s the money you can afford to lose, and which as a result can be dedicated to high-risk/high-reward investments
Its role in your portfolio
Risk capital allows you to pursue potentially lucrative investments such as individual stocks, startups, and derivatives. You use it for the investments which can succeed or fail spectacularly.
It is your safeguard against one of the worst mistakes a retail investor can make: rolling the dice with critical money. Tying your 401k to a single venture is like going to the casino and putting it all on black. When you lose, you lose big.
At the same time, managing your money too conservatively can lead to minimal growth. Indeed, a sluggish portfolio can lead investors to make impulsive and poor decisions out of frustration.
That’s the role of risk capital: to let you profit off of big opportunities without risking your retirement on one guy’s big idea.
How to identify it
One rule of thumb is that risk capital should make up no more than 10 percent of your portfolio. That’s a good starting point, but ultimately your investment comfort zone is highly individual.
Speaking of comfort zones, how should you keep your portfolio safe from volatility?
Risk capital is the percent of your portfolio you could see zeroed out in pursuit of higher profits, so start with two questions:
- How much could you afford to lose completely?
- How much of your income could you dedicate to rebuilding a loss?
This will give you a sense of what you can work with.
Once you draw these lines keep them firm. When an exciting investment comes along it will be tempting to pull some extra money over, but discipline is an important part of smart investing.
The younger you are the more risks you can take.
This common wisdom, although not universal, is true more often than not. As they approach retirement older investors will need liquidity sooner, which means less time to recover from a stock that goes wrong.
Similarly, with more working years ahead younger investors simply have more future income with which to rebuild from a loss.
Finally, when will you need the capital? Long term investments can sustain higher levels of risk, while the money you’ll need in the near future should be more carefully managed. Investors who plan on buying a house, for example, might not want to leave their money in a savings account, but don’t want to lose it either. (Earmarked money like that might be excellent for Treasury bonds.)
How to use it
Risk capital can serve two main purposes: speculation and market education.
In both cases, there’s real value, but also the real possibility of loss.
Specific stocks are excellent for risk capital. Untethered to the market at large, they have the potential for explosive growth but can bottom out completely.
New ventures are also the right place for this money. This can include developing technologies, startup companies and mineral exploitation, all of which can lead to all-or-nothing gambles.
Finally, investors who want to explore derivatives should do so with their risk capital. Although they are highly sophisticated products futures and options can do very well under the right circumstances. This is an area that the average investor can learn about, but the education will probably come with a price.