Risk tolerance

An important part of the investment decision process

There’s no single answer to the question of how much investment risk you should take on. It depends on your individual circumstances, goals and comfort level with risk. Some people are more comfortable with risk than others. Some people are willing to take on more risk in order to achieve their goals. And some people have different tolerance for different types of risk.

Understanding investment risk and determining what level of risk you feel comfortable with before you invest is an important part of the investment decision process. Your potential returns available from different kinds of investment, and the risks involved, change over time as a result of economic, political and regulatory developments, as well as a host of other factors.

There are a few different ways to think about risk tolerance. One way is to consider how you would feel if your investments lost money in the short term. If the thought of seeing your account balance go down makes you anxious, you may be more risk-averse.

Volatile investments

On the other hand, if you’re comfortable with the idea of short-term losses in exchange for the potential for long-term gains, you may be more willing to take on risk.

Another way to think about risk tolerance is to consider how much volatility you’re comfortable with. Volatility is a measure of how much prices fluctuate over time. Investments that are more volatile will have bigger ups and downs in their value, while less volatile investments will have slower, steadier price changes.

Stability and slower growth

Some investors are attracted to the potential for big gains from investments that are more volatile. Others prefer investments that offer stability and slower growth.

So understanding your risk tolerance can help you make better investment decisions. It can also help you avoid taking on too much risk – or not enough risk – for your goals. Your investment goals and timescales will also influence how much risk you’re willing to take. What you come out with is your ‘risk profile’.

Different types of investment

None of us like to take risks with money, but the reality is there’s no such thing as a ‘no-risk’ investment. You’re always taking on some risk when you invest.

For example, funds that hold bonds tend to be less risky than those that hold shares, but there are always exceptions.

Losing value in real terms

Money you place in secure deposits such as savings accounts risks losing value in real terms (buying power) over time. This is because the interest rate paid won’t always keep up with rising prices (inflation).

On the other hand, index-linked investments that follow the rate of inflation don’t always follow market interest rates. This means that if inflation falls, you could earn less in interest than you expected.

Inflation and interest rates over time

Stock market investments might beat inflation and interest rates over time, but you run the risk that prices might be low at the time you need to sell.

This could result in a poor return or, if prices are lower than when you bought, losing money.

You can’t escape risk completely, but you can manage it by diversifying investments over the long term. You can also look at paying money into your investments regularly, rather than all in one go. This can help smooth out the highs and lows and cut the risk of making big losses.

Capital risk

Your investments can go down in value, and you may not get back what you invested. Investing in the stock market is normally through shares (equities), either directly or via a fund. The stock market will fluctuate in value every day, sometimes by large amounts. You could lose some or all of your money depending on the company or companies you have bought. Other assets such as property and bonds can also fall in value.

Inflation risk

The purchasing power of your savings declines. Even if your investment increases in value, you may not be making money in ‘real’ terms if the things that you want to buy with the money have increased in price faster than your investment. Cash deposits with low returns may expose you to inflation risk.

Credit risk

Credit risk is the risk of not achieving a financial reward due to a borrower’s failure to repay a loan or otherwise meet a contractual obligation. Credit risk is closely tied to the potential return of an investment, the most notable being that the yields on bonds correlate strongly to their perceived credit risk.

Liquidity risk

You are unable to access your money when you want to. Liquidity can be a real risk if you hold assets such as property directly and also in the ‘bond’ market, where the pool of people who want to buy and sell bonds can ‘dry up’.

Currency risk

Currency risk is the potential risk of loss from fluctuating foreign exchange rates when investments are exposed to foreign currency or in foreign-currency-traded investments.

Interest rate risk

Changes to interest rates affect your returns on savings and investments. Even with a fixed rate, the interest rates in the market may fall below or rise above the fixed rate, affecting your returns relative to rates available elsewhere. Interest rate risk is a particular risk for bondholders.