Lesson ten: What is investment risk?

Thinking about risk

When you invest, you need to think about risk because there’s always the chance that you could lose some or all of your money. 

If it all goes well, you could be in the money and end up with a lot more than you started with. When you’re investing, you need to think about whether you’re willing to take risks with your money and how much risk you’re able to take.

Investment risk

In the financial world, the word ‘risk’ usually describes the range of possible returns on your investment. It is measured by how much an investment can go up or down. This is also known as ‘volatility’. Generally, the more often an investment goes up or down, the riskier it is.

Taking more risk could lead to a bigger return on your original investment, but equally it can lead to more loss. Taking less risk can mean that the return is lower, but there might not be as much loss.

Is risk good or bad?

The short, and fairly unhelpful, answer is that it can be either. The long answer is that it depends on what your goals are and if you need to take any risk to get there. Studies have shown that the pleasure of making a sum of money is less than the pain of losing the same amount – think winning a new car in a raffle, compared to losing an existing one!

It makes sense that people are often keen to avoid losses, but low interest rates mean a decent risk-free return on cash is difficult, so many people will take some risk to get the returns they want.

Would you rather have a guaranteed 2% return or the possibility of earning (or losing) 10% through riskier investments? There’s no right or wrong answer, but it’s really important to consider what your attitude is towards risk and how much risk you can afford to take before making any decisions.

How much risk should I take?

There is no one size fits all and the answer will depend on your personal circumstances. You may have friends or family who try to help, but it could affect how you view risk. What works for them may not work for you.

Here are three things to consider when thinking about risk

1. Your ‘capacity for risk’

This is how much money you could lose without it making a significant impact on your standard of living. Your capacity for risk will depend on how much money or other assets you have, how easy it is to access them, your regular income (i.e. your salary), how long you want to invest for, what outgoings you have and any debt you may have to pay off.

Think about if you lost all the money you put into a high-risk investment. Would you still have enough money to pay your rent or mortgage along with your other bills and student loan and then get a takeaway on a Saturday? If the answer is no, then you might want to reconsider which investment you choose.

2. How long you are investing for

History shows that more volatile investments tend to recover from market downturns over long periods of time. So the longer you stay invested, the more risk you could afford to take.

But if you don’t want to keep your money invested for a long time or have a fixed date to stop investing, then you could be caught out by a drop in the market and lose money.

For instance, someone who has just started their career and is planning to work for many decades to come (sorry if that’s only just hitting you) may be able to take a higher level of risk than someone who is planning to retire in five years.

3. Your emotional reaction

Holding your nerve is a necessary part of investing, and everyone reacts differently when things aren’t going smoothly.

It is natural to be worried at the thought of losing money, but in most cases the worst thing you can do is completely panic and sell everything you have whenever the market takes a downturn. You haven’t given your investments a chance to recover and you could lose some of your savings. Keep checking on your investments to make sure they’re watered and well-fed and there are no poor performers. But also, keep the faith!