Every day you carry out hundreds of tasks that could be potentially dangerous. From boiling the kettle and risking getting burnt to getting out of bed and potentially falling and hitting your head, no action is without risk. But, clearly, not every task has the same level of risk.
It’s the same with investing – by its very nature, all investing has some risk attached to it, but it varies depending on type. It’s up to you to decide how much risk you’re willing to take and how much money you can afford to lose in pursuit of your financial goals.
Investment – it’s a risky business, but it can pay off in the long run.
What is investment risk?
When you invest your money, the hope is that the investment will increase over time and you would get back more than you put in, but that’s not always the case.
Investment risk can take many forms. However, the thing to remember is the greater the risk, the greater the chance of higher returns – and on the flipside, the greater the chance of losing more (or even all) of your money. Conversely, you could choose investments with a lower risk but the return is likely to be lower and you run the risk of having the value of your money being eroded by inflation.
Whatever investment you choose, you have to accept some level of risk, but how much depends on what you want to achieve and how quickly you hope your money will grow.
How to mitigate investment risk
Time is the best cure for a broken heart, and it has the potential to be a good healer for investments too – time gives your investment more time to recover if it falls in value. So, if you’re investing for 5 years or more, you may be prepared to take on more risk for the opportunity of a higher return. However, it’s worth noting that even with a large window, there’s no guarantee that your investment will grow and you could still lose money.
It’s not just to do with what you’re comfortable with, but what your investment goals are. You should regularly review your investments to make sure they remain on track to meet your investment goals.
When you’re close to reaching your investment goal (the reason why you’re investing), you should think about choosing lower risk investments, like cash, bonds or gilts, to help protect the value of your money from significant falls, or you won't have enough time to recoup your losses.
Attitude to risk
Your attitude to risk is really made up by two key components. The first one is about what you can afford to lose and is commonly known as ‘capacity for loss’. If you have more wealth and can withstand sizeable losses without it impacting your current or future lifestyle then your ability to take risks is likely to be higher. If your financial goal is over a long period of time then you may also be able to accept higher risks with your investment as you will have more time to recoup any losses.
The second part of attitude to risk is your willingness to take risk. This refers to how emotionally and mentally comfortable you are taking risks with your money. This is often referred to as your ‘risk tolerance’. If the thought of losing money is keeping you up at night, then you will be less willing to take on risks therefore meaning you have a lower risk tolerance. It is important that you consider these two elements of attitude to risk when selecting the level of risk for your investment.
What do you think? Are you going to take higher risks for a chance of higher returns but potentially higher losses, or play it safer with the potential for lower returns and losses?
Choosing a fund to invest in
Once you’ve decided on the level of risk you’re comfortable with, you can choose the kind of fund you want to invest your money in. The trick is to choose a fund that closely aligns to your attitude to risk.
Each fund will invest in either a specify type of asset or a mixture of assets – assets are basically a way of categorising different types of investments. These all have different levels of risks – some of these assets are riskier than others, but each fund aligns to a specific attitude to risk.
Take a look at each asset class to find out more about their potential for 'risk and return' in our 'Nuts and bolts of investing' article.