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An understanding of investment risk is crucial to maintaining an appropriate long-term investment strategy. Risk can (and should) be interpreted in many ways. To some people, risk means the likelihood of achieving a return below their expectations, for others it could be the chance of losing money, failing to keep pace with the cost of living or failing to meet a specific target. What all of these have in common however, is that they relate to uncertainty.
Investing always involves a degree of risk, it’s generally understood that the higher the risk you take, the higher the potential reward but also the potential for loss. What’s often difficult is determining where you should sit along the scale of potential risk and reward, and then determining how you should design your portfolio accordingly.
Risk tolerance – how risk makes you feel. If you can’t sleep at night worrying about your portfolio then it’s likely you’ve taken on more risk than you’re comfortable with. On the flip side, if you’re taking too little risk, you could be disappointed by your returns or you risk inflation reducing the buying power of your money
Risk capacity – how much you can afford to lose. We all go into investing in the hope of making money over the long-term but, in taking on risk, we accept (to varying degrees) that our investments might fall in value along the way. Think about what it would mean for you if your investments fell in value and make sure your portfolio reflects this.
Time horizon and objectives – if you’re investing for a longer period of time, you may be able to take on more risk in the hope of getting higher rewards, because you’ve got more time to recover from any downturns. The nature of your goals is also important – if you’re investing in order to build up a sum for a specific purpose, the potential of not meeting that goal might limit the amount of risk you’re willing to take.
Knowledge and experience – individuals with more financial and investment knowledge are generally more willing to accept investment risk. You don’t need to be an expert to start investing but you do need to be comfortable that you understand the nature of the investments you hold.
Having decided how much risk you’re willing and able to take with your money, the next step is to design your portfolio accordingly.
All investments sit somewhere on a scale from low risk/low potential reward (for example cash) to high risk/high potential reward (for example individual company shares). Designing a balanced portfolio to match your chosen level of risk is about choosing different types of investments and blending them together in a way which maximises your potential returns but which ensures you’re not taking on more risk than you’re comfortable with. Learn more about this process in the next section.