How to think about risk

When it comes to investing risk can be a good thing, which to many people is counterintuitive.

| 7 min read

Risks are to be avoided right? We buckle up when driving, steer clear of the seafront during a storm and avoid leaving a candle unattended. Just a few examples of the thousands of everyday ways we reduce or eliminate risk, probably without even thinking about it much.

Yet when it comes to investing, risk can be good, which to many people is counterintuitive.

Look up synonyms for risk and you will find: danger, jeopardy, peril, hazard, and threat. All words with negative connotations. No wonder many of those new to investing start to hear alarm bells as soon as the concept of investment risk is introduced.

Defining risk

There is also confusion as to what risk, in the context of investing, really means. Many people assume risk means losing all their money, and investments labelled ‘high risk’ carry that possibility. In some, extreme, cases that may be true, but for the majority of mainstream products it is highly unlikely.

The financial industry defines risk a different way. It sees it as a measure of volatility – the magnitude of ups and downs. High risk is a rollercoaster ride, low risk a lazy river. Quite often that’s based on what happened in the past, which isn’t necessarily like the future so that in itself has to be taken with a pinch of salt.

What we can say for sure is that at times investors are better paid to take risks. Generally, when market valuations are lower and more investors are despondent. On other occasions, when valuations are higher and investor consensus is more confident, you are not so well compensated. A significant part of investing is based on human psychology.

The bottom line, though, is that to receive higher investment returns you have to take more risk. How and when you do results in different outcomes, but you must take at least some risk if you want a decent return on your money over the long term – and give yourself the best chance of meeting your life goals.

Risk or opportunity?

Not investing – leaving money in cash – is a high-risk approach in itself. It might sound crazy, but it’s true in the long run. Cash does a terrible job of growing your money. So bad that it shrinks your wealth over time – at times quite quickly. A pound has lost three-quarters of its spending power over the past thirty years (source: Bank of England Inflation Calculator). Sure, you will have got some interest on your pounds in a decent savings account over the years (well up until the past decade or so anyway) but it will have lagged far behind rises in the cost of living.

You won’t lose money on cash, the value in pounds and pence won’t go down. That’s important, and it’s why you need to keep some on hand for when life throws you a curveball. But having lots of your net worth in cash is a missed opportunity over longer periods.

So, pile into high-risk investments then? Not so fast. Taken to the extreme, investment risk can be detrimental. Let’s not beat about the bush, it can lead to financial ruin if you take a gambler's approach.

Take investing in a single company. You are putting your capital in the hands of one business and one management team. That’s way too much risk for most people, though being an entrepreneur often means putting all your eggs in one basket, either through necessity or absolute conviction. Elon Musk, the founder of Tesla, famously gave the electric vehicle company a 10% chance of succeeding during its early years. It’s now one of the biggest auto manufacturers globally, but there are several points at which it could have failed along the way.

Investing using debt or ‘leverage’ is also very risky. If something goes wrong, you could lose a lot. To thrive, you have to survive, so while you need to take risk, room for error is essential. That’s why the concept of diversification – spreading your money around lots of different investments – is so important.

So too the need to take a long-term view to ride out market ups and downs and allow the compounding of returns to do the hard work. Yes, he’s been a pretty good investor over the years, but more than 97% of Warren Buffett's wealth has been accumulated after the age of 65. Time, and staying in the game through avoiding excessive risks, has been more important to the world’s most famous investor than stock picking.

Keeping a cash reserve so you can leave investments untouched is also vital, and you should never borrow to invest. If you borrow, you may be a forced seller.

For most people, then, it’s a case of striking a happy medium. Taking enough risk to generate strong, long-term returns ahead of inflation but avoiding excessive risk that could wipe out a swathe of your wealth, leaving you with insufficient capital to recover.

Risk is personal

Everyone has a different ‘appetite’ for risk. It’s unique to you and often depends on your financial circumstances, time horizon and personality.

Depending on your situation, you will have a certain amount of ‘risk tolerance’ – the mental willingness to accept risk. You’ll also have a ‘capacity for risk’ – how much you can, in practical terms, afford to risk.

These are clunky terms, but they describe a simple point. The less money you have, the shorter time you have and the more cautious your personality the less able you are to take on risk. Those with little or no savings or, even worse, significant expensive debt should not be looking to invest. Their capacity for loss is essentially zero.

Similarly, someone with a lot of money that needs to use all of it in a relatively short time frame – for instance for a deposit on a house – shouldn’t be taking on investment risk either. Anything less than five years is generally considered too short to put yourself at the mercy of market fluctuations.

There’s a need to match risk to circumstances appropriately, but financial literacy and confidence also play a role – hence the term ‘tolerance’. Some people tend to be confident, others are naturally more cautious. Either way, being over-optimistic or too timid, there can be negative consequences. The former can lead to excessive risk and losses that are hard to make up, the latter to missed opportunities and poor long-term returns. Striking the right balance is the key to getting the most from your money without losing sleep at night.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

How to think about risk

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The information in this article is based on our understanding of UK Legislation, Taxation and HMRC guidance, all of which are subject to change. The tax treatment of pensions depends on individual circumstances and is subject to change in future. This article is solely for information purposes and does not constitute advice or a personal recommendation.

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