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Investing your money always involves taking a degree of risk. The question is, how much are you prepared to take to get a good return on your cash? In the third part of our investing for beginners series, we take a closer look at investment risk – helping you to work out both your attitude and your capacity for risk.
What’s on this page?
In simple terms, investment risk refers to the potential for your money to fall in value. Craig Rickman, personal finance editor at Interactive Investor, explains: “In an ideal world, you could get big returns without taking too much risk. But that’s rarely the reality. Investments that have the potential to make lots of money are typically subject to equally heavy losses. On the flip side, safer investments bring more certainty, but the prospects for increasing in value are low.”
But risk doesn’t just refer to stock market investments. When we make a decision to keep a big pot of money in the bank, we’re taking a risk too. Laith Khalaf, head of investment analysis at AJ Bell. says: “Many people think keeping all their money in cash, such as in a savings account, is completely safe, but it’s not entirely risk-free. The biggest risk with cash is inflation, which is the rising cost of living.”
If returns on cash are lower than inflation (bearing in mind you might also be paying tax on your savings interest), the spending power of your money will be reduced in real terms as the years pass.
All of this means that to invest successfully and get the growth you need to achieve your financial goals, you need to take a balanced approach – understanding not just your own attitude to risk but your capacity for risk too.
Your attitude to risk (sometimes called risk tolerance) is personal, says Khalaf. It’s about how comfortable you feel around the value of your investments rising and falling over time. “Some people don’t mind taking risks if it means they might get higher returns, while others prefer to play it safe, even if that means lower growth."
It’s also worth thinking about your aspirations for investment growth, since higher growth tends to come from higher-risk investments – which, of course, are also more likely to lose money. Your capacity for risk, on the other hand, relates to the amount of risk you can afford to take, based on your wider financial situation.
Khalaf explains: “Even if you’re comfortable with risk, you need to consider things like whether you have savings set aside for emergencies, how long before you need the money you’re investing, and whether you could afford to lose some of your investment and still meet your financial goals.”
Typically, the more time you have before you’ll need the money, the greater your capacity for risk will be. As such, younger investors may often be willing to take more risk. But that’s not to say older investors should necessarily be cautious– especially if they have a healthy reserve of cash in a savings pot and won’t need to access their investments in the next five to 10 years.
Alice Haine, personal finance analyst at Best Invest by Evelyn Partners, says: “Remember appetites to risk can vary within relationships or between friends and across age groups. What works for you may not work for someone else.”
Medical advances and longer life expectancy also mean there’s greater pressure on older people’s finances, she says. “Retirees may live longer than planned, and investors with ultra-cautious portfolios could end up sitting on the sidelines as the markets continue to move upwards.”
Megan Rimmer, a chartered financial planner at Quilter Cheviot, agrees: “While it is important not to take too much risk, it is also important not to be too cautious too early, so striking the right balance with your investments is key. If you’re nearing retirement, you may feel you need to reign in the risk you’re taking, but if you don’t intend to use the money in the near term, then taking a higher level of risk could result in better returns in the long run.”
If you’re new to investing, there are plenty of online tests you can complete to get started. Rickman says: “These electronic questionnaires usually involve 10 to 15 statements, to which you respond by saying whether you either strongly agree, agree, are neutral, disagree, or strongly disagree. A common statement might be, ‘I prefer investments that are safe, even if it means growth is low.’”
He adds: “Once you’ve completed the questionnaire, you’ll receive a score, together with a description about what this means. This should provide you with some steer on your overall attitude to risk, and importantly, the degree of ups and downs you’re happy to take.”
To make the most out of these questionnaires, it’s important to keep a level head and think about your capacity for loss. “If a substantial loss on a particular investment would dramatically affect your living standards, then it might not be appropriate to you,” says Haine. “However, if you have a long-term approach and are investing money that you can leave to ride out any financial storms along the way to give the investments time to grow, then you might be able to afford to take on a higher level of risk.”
But, however pragmatic you’re trying to be, you shouldn’t overlook your emotional response to losses. She adds: “If you cannot bear to see your investments go down in value, something that may encourage you to panic and sell everything you own every time there is a market downturn, then you are likely to need low-risk options.”
Striking the balance between risk and reward involves the head and the heart. You need to take into account factors like your time horizon and the levels of loss you can afford, as well as your personality traits and likely emotional responses. But it’s also important to think about the steps you can take to control risk, before you push some investments off the table.
For example, Rimmer points out that by spreading your investments across different asset classes and geographical regions, it’s possible to reduce your overall risk. “While investing can often be perceived as risky and this may cause people to shy away, a well-structured and well-diversified portfolio that is managed sensibly ought to protect your investment from inflation and the decline in purchasing power over time. By investing, you can build a portfolio of a range of assets, such as equities, corporate bonds, gilts, property shares and sometimes alternative assets, which can amount to a relatively low-risk portfolio that is likely to perform better than cash.”
That said, this doesn’t eliminate the risk that the value of your investment will go down.
Once you’ve got an understanding of investment risk and know how much you happily afford to take, you’re in a much better position to start investing. With that in mind, we’ll be explaining how to choose the right investment platform next week, followed by how to choose investments and build a portfolio.
