Know your risk tolerance when investing in the stock market

Opening a brokerage account is often one of the first steps beginning investors take when they start investing in the stock market.

You’ll first have to choose whether a full-service or discount broker is right for you. (This is one of the questions we help you answer in our new special report, “Canadian Stock Market Basics: How to Trade Stocks and Make Good Investments in Canada.”)

If you choose to use a full-service broker for investing in the stock market, you’ll have to fill out an application form to set up your account. When you do, we think you should pay special attention to two sections: “risk level” and “investment objectives.” (You don’t need to fill these out with a discount broker, but the answers are well worth thinking about nonetheless.)

Under “risk,” you assign percentages to designate the risk you can accept — high, medium or low — in your RRSP and in your non-RRSP or “trading” account. Each set of risk percentages should add up to 100%. The form doesn’t explain what it means by high, medium or low risk. But it’s fair to say that “high” risk investments carry a substantial chance of big losses, as in penny stocks, options and so on. A government bond would be “low” risk. Well-established, profitable and dividend-paying stocks would be “medium” risk.

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Taking risks inside your RRSP can be doubly costly

Many investors put 10% or 20% in the high risk box for each account. However, it’s far better to put 20% to 40% in the high risk box for your trading account, and 0% in high risk for your RRSP. Losses are far more costly in your RRSP than in your trading account, because you lose your money and an opportunity for tax-deferred capital growth.

Moreover, if you list anything above 0% in the high risk box, your broker may feel free to propose high-risk investments to you. If they backfire, you won’t be able to claim they were inappropriate for your risk level.

It pays to invest for the long term

Under “investment objectives,” you set percentages in each of four categories — short-term, medium-term and long-term capital gains, and income — that add up to 100%.

We advise clients to split the 100% between long-term gains and income, and leave short-term and medium-term capital gains at 0%. Most investors wind up losing money when they seek short-term or even medium-term capital gains.

Of course, sometimes you’ll buy investments, then quickly change your view and sell. But your goal should be to acquire a diversified portfolio of high-quality investments that you expect you’ll want to hold onto indefinitely.

As a member of TSI Network, you may have already seen Canadian Stock Market Basics: How to Trade Stocks and Make Good Investments in Canada. If you haven’t yet read this new free report, click here to download your copy today. I’d also encourage you to share the report with a friend. It’s my “thank you” just for signing up for my free daily updates.