Written by 4:53 pm Investing

How to think about investment risk

About 3 minutes to read

If you had £10,000 invested, how much of it could you stand to lose? £2,000? £5,000? At what point would you be tempted to pull your money out of the market and stuff it under your mattress?

Studies into the psychology of investing have shown us that people tend to feel the ‘pain’ of a loss twice as strongly as they feel a positive boost from an investment gain. That’s why it’s easy for any investor, no matter how experienced, to find themselves making investment decisions based on emotions like fear and uncertainty. To avoid this, and make better decisions, you need to understand investment risk. 

What is risk?

Risk is the uncertainty every investor faces. When investing, risk is the potential loss of investments; however, you can’t get returns on those investments without taking some risk. In general, the higher the risk, the greater the potential rewards. Different types of assets (assets are things you invest in) are considered to have different risk levels – shares, for example, are generally higher risk and higher potential returns than bonds. Another side of the coin to consider is volatility – the ups and downs investments go through over time – meaning you may have a bumpy ride on the way to those expected higher returns.

Some risks stem from the things you hold in your portfolio, such as a company whose shares you own going bust, there are also other types of risk such as rising inflation, currency risk, or ‘black swan’ events that no-one can predict (a global pandemic, for example). It sounds scary, but the way to think about risk is that it’s not something to fear, because without it you can’t make a return. It’s just part and parcel of investing. And we know what, given enough time, the risks of investing are worth the rewards – a long-term investor in the UK’s main stock market would have earned on average 7.8% a year. Compare that to cash in a savings account – it will earn you virtually nothing, and its real value will be eaten up by rising inflation. There is no investment risk associated with your cash savings. 

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How much risk can I take?

There’s a balance to be struck here. Take more risk that you’re comfortable with, and you could face heavier losses than you can stand. Take too little risk, and you could end up with lower returns than you need – if you’re investing for retirement, your investments must perform well enough to give you the money you’ll need to live on. 

How can you decide how much risk you can stomach? When you invest with a wealth manager or financial adviser, you’ll usually be given a risk questionnaire which will determine how they build you a suitable portfolio, which can change over time as your risk attitude changes. 

Your age is an important factor – when you’re young, you can afford to take more risk because you have years ahead of you to make up any losses. You should also think about what you are investing for. If it’s for a medium-term goal such as a house purchase or a wedding, you’ll probably not want to take much risk because you’ll need that money fairly soon. But if your goal is building up retirement savings or investing on behalf of a child, you can take more risk because statiscally you’ve got time on your side. 

How can I reduce risk?

  • Diversification

One of the main ways to reduce your risk is to have a broad spread of different investments like shares, bonds, property and cash. This is called diversification. It means that when one thing is not performing well, your other investments should balance it out. We spoke about diversification in more detail in this article.

  • Regular investing

When you drip-feed money into the market with regular investments over time, you buy shares at different prices, getting more of them when they’re cheap and fewer when they’re more expensive. Over time, this should spread your risk. 

  • Thinking long term

If you’re investing, you should really be able to keep your money in the markets for at least three to five years and not withdraw it when things get tough. One study found that, since 1984, 70% of average investor underperformance happened in 10 key periods in which investors panicked and pulled their money out. Remember that red numbers on a screen don’t mean you’ve actually lost money – you only make a loss when you sell. 

  • Buying what you know 

Keep it simple. Don’t invest in risky speculative investments or anything you don’t fully understand. 

In investing, there are no guarantees, and you’ll need to accept some risk to reap the eventual rewards. But history shows us the longer you stay invested the greater the likelihood of positive returns. 

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Visit https://ikigai.money to find out more.

Maurizio & Edgar, Co-Founders, ikigai

When investing, your capital is at risk.

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Last modified: 26 November 2020