Understanding Risk

Investing goals and risk tolerance

Understanding the risk/reward relationship and working out how much risk you are comfortable taking is an important part of investing.

As a general rule, the more risk you take the greater the potential return, but also the greater potential loss.

Before you start investing there are a few things you need to consider.

What's your attitude to risk?

Are you cautious or adventurous or somewhere in-between? How would you feel about your investments fluctuating in value? Consider, too, how much money you could afford to lose.

What are you investing for?

A short-term goal like a new car or a holiday? Or a long-term one, such as a child's education or your retirement?

What's your time horizon?

If you're investing for a long-term goal often regarded as 5-10 years or more, you might take more risk for potentially higher returns as you have time to ride out market up and downs.

Different levels of risk

Each asset class carries a different level of risk. In order of low to high risk they are generally seen as:

Cash

Deposits with banks and building societies, governments and large corporations. May also include investments with more risk (and return) than standard bank deposits.

Fixed Income

Also known as bonds – think of them as an IOU to a company or government.  In return for lending your cash to these companies or governments for a fixed period of time, the issuer promises to make regular interest payments.

Property

The most familiar notion of investing in property is through home ownership or buy-to-let. However there is another way to access the market – through funds that invest directly in commercial property, retail premises and offices or by investing in the shares of property companies.

Equities

‘Equities’ are simply another term for shares. The investor has a share in the ownership of a limited company listed on a stock exchange. Investors choose equity investment in the hope that the value of their shares will increase over time, providing long-term capital growth. 

Being cautious

Playing safe could also carry risk. Keeping your money in a building society or savings account carries minimal risk, but inflation could erode its value and you could miss out on greater returns.

Spreading risk and diversification

The value of investments can rise and fall over time. This is called volatility. Higher risk investments tend to be more volatile than lower risk ones.

Investing across different asset classes helps to spread risk. This is called diversification.