As an Independent Financial Adviser (IFA) based in the UK, I often meet clients who are unsure about how much investment risk they should take. The question of risk is central to any investment decision because, quite simply, risk and reward go hand in hand. Yet, the amount of risk that’s right for one person can be very different from what’s suitable for another.
In this post, we’ll explore how to determine the right level of investment risk for you. Whether you’re new to investing or just rethinking your approach, understanding risk is the key to making informed financial decisions and working towards your financial goals.
What Is Investment Risk?
Investment risk refers to the possibility that your investments might not perform as expected, and in some cases, you could even lose money. Different types of assets carry different levels of risk. Generally speaking, higher risks will potentially offer higher returns, and lower-risk investments tend to offer more modest returns.
Here are the key types of investment risks to be aware of:
- Market risk: The risk of an investment losing value due to changes in market conditions, such as economic downturns or political instability.
- Inflation risk: The risk that inflation will erode the value of your investment returns over time.
- Credit risk: The risk that a borrower will default on a loan or bond, leading to a loss for the investor.
- Liquidity risk: The risk of not being able to sell your investment quickly without incurring a loss.
- Currency risk: The risk of currency exchange rate fluctuations impacting your returns.
How Much Risk Should You Take?
Determining how much risk you should take depends on several factors:
Your Financial Goals
It’s important to know what you want to achieve from investing. The first question to ask yourself is: What am I investing for? Financial goals should be specific targets or objectives you set to manage, grow, and secure your financial future. Your financial goals will determine what kind of risk you might want to take. Whether you are saving for a property deposit, your retirement or children’s education, generally the longer your investment horizon, the more risk you can afford to take.
Your Investment Time Horizon
Once you’ve set your goals, you should have a rough estimate of how long you’ll need to invest and the annual returns required to reach them on time. The longer you invest, the better. More time in the market means more opportunity for compounding to work in your favour—a powerful tool in every investor’s arsenal.
If you’re investing for a decade or more and aren’t nearing retirement, you can afford to take a more adventurous approach with your investments. Just be sure you’re comfortable with the risks involved. Over the long term, investments generally perform better, and any short-term fluctuations are often smoothed out, as markets tend to recover over time. However, remember that no investment comes with guarantees.
For a 5-to-10-year timeframe, consider a more cautious strategy to avoid unnecessary risks. Market drops can impact shorter-term investors, potentially forcing them to sell at a low point if they need access to funds.
If your horizon is less than five years, it’s best to keep funds in cash savings and look for the best rates available.
Your Personal Risk Tolerance
Risk tolerance is your emotional capacity to handle the ups and downs of investing. Some people can comfortably weather market fluctuations without panic, while others may feel uneasy when their investments drop in value. Understanding how you respond to risk is crucial. If seeing your portfolio decline significantly would keep you awake at night, you may prefer a more conservative approach. To better manage your emotions and risk, ask yourself how you’d feel about the value of your investments dropping by 5%,10% or perhaps 20% overnight.
You can assess your risk tolerance through questionnaires, or with the help of an adviser, who can gauge how much volatility you’re willing to handle.
Your Financial Situation
Your overall financial health will influence how much risk you can take. If you have a stable income, little debt, and a solid emergency fund, you may be able to afford more investment risk. However, if you are more financially vulnerable or nearing retirement, you may need to be more cautious, as you cannot afford substantial losses.
Matching Investments to Your Risk Profile
Once you’ve assessed your risk tolerance, you can choose investments that match your risk profile.
- Low-risk investments: These include cash, savings accounts, and government bonds. They are ideal for those with a low-risk tolerance or short-term financial goals, as they provide stability but offer relatively low returns.
- Moderate-risk investments: Balanced portfolios that combine bonds, equities, and other assets can offer a middle ground. They’re often suitable for investors who are looking for growth but want to avoid extreme volatility.
- High-risk investments: Equities (shares in companies), and alternative investments like property or commodities tend to be higher risk but also have the potential for higher returns. These are more suitable for investors with a long-term horizon and a high-risk tolerance.
Diversification: Spreading Risk
Diversification is one of the most effective ways to manage risk. By spreading your investments across different asset classes, sectors, and geographical regions, you reduce the chance of your portfolio being heavily impacted by a downturn in one area.
For example, if you invest in a mix of stocks, bonds, and property, a decline in the stock market may be offset by stronger performance in bonds or property. Diversification doesn’t eliminate risk, but it can smooth out the ups and downs of your investment journey.
Regular Reviews Are Essential
Your risk tolerance isn’t static. It can change as your life circumstances evolve. For instance, as you approach retirement, you may want to shift to lower-risk investments to protect your portfolio. That’s why it’s important to review your investment strategy regularly and adjust accordingly.
Final Thoughts
There is no one-size-fits-all approach to investment risk. The right level of risk for you depends on your financial goals, your time horizon, your risk tolerance, and your financial situation. A well-balanced investment strategy, tailored to your unique needs, can help you achieve your objectives while managing risk effectively.
If you’re unsure about how much risk you should be taking, seeking advice from a financial adviser can be invaluable. An adviser can help you assess your situation, develop a personalised investment plan, and guide you through market ups and downs with confidence.
Investing can be both rewarding and nerve-wracking, but by understanding your own risk profile and aligning your investments accordingly, you can make the process work for you.
If you have any questions about your investment risk or would like personalised advice, feel free to get in touch with me at Glade Financial. We’re here to help you make informed, confident decisions for your financial future.
