How much investment risk is right for you?

When you start investing, one of the first things to think about is your risk tolerance. This is not something that necessarily lines up with how you generally approach risk elsewhere in your life.. 

Someone who is comfortable with the risks of rock climbing or jumping out of an airplane, might not so easily be able to tolerate the risks associated with investing their money, especially the chance that you might lose some or all of it. 

So here’s how to work out how much investment risk is right for you.

Some articles on the site contain affiliate links, which provide a small commission to help fund our work. However, they won’t affect the price you pay or our editorial independence. Read more here.

Here at Be Clever With Your Cash, we’re not regulated to give you financial advice. We aim to give you the facts about a provider or investment but it’s up to you to decide if it’s suitable for you. If you’re looking for more personalised guidance, find a financial adviser who can give you specific advice. Remember that your capital is at risk when investing — don’t invest more than you are prepared to lose. 

What is risk?

When we talk about risk in investing, we’re referring to the chance your money could lose or gain value.

Risk exists in all types of investments, even if it may not be obvious. For example, keeping your cashin the bank is often thought of as ‘safe’ or ‘low risk’. However, there is still the risk that your savings may not earn enough interest to keep pace with inflation – effectively losing their value over time. 

And in the worst case, there’s the risk that the bank goes bust and your money is lost. In the financial crisis of 2008, this did happen to some banks and the Government stepped in to help rescue savers. Protection from the Financial Services Compensation Scheme (FSCS) helps mitigate this risk, but it’s something to watch for.

But the risk that most people think of is the high risk of investing in shares. Here you have to deal with the ups and downs of the stock market, known as ‘volatility’ if you want to get technical. This can cause the value of your investments to go up or down. And the risk that the companies that you own shares in can run into trouble or in the worst case go bust. 

Who can tolerate high risk?

Some people can tolerate this high risk better than others. Factors such as personality, your family background, financial status and goals all play a part in shaping what level of risk you’re prepared to take on. But there can be a mismatch between your ability and your willingness to take risk.

In general, if you’re wealthy, with a high income and low debts,, or are prepared for a long investment term (five to 10 years or more) you’re in a better position to take on investment risk. If you’re 21 and don’t need the money until you’re 60, you can afford to hold on and weather any stock market storms.

But your willingness often has more to do with your psychology than your finances. You may find the prospect of volatility or the chance of investment loss too worrying. Or you may be very relaxed about it. Or something in between.

How do I work out my approach to risk?

Some firms offer free risk questionnaires. For example, Standard Life’s attitude to risk questionnaire contains 13 multiple choice questions which you need to answer to discover your category. It should take less than 5 minutes.

Some robo advisers also direct you to a tool that helps you identify your attitude to risk before choosing a fund.

Alternatively, you could pay for the services of an independent financial adviser who will talk to you to find out your risk tolerance and then choose some investments that align with this.

Cash vs investing

Financial advisers say people often overlook the fact that inflation can damage the value of their cash and over estimate the risks involved in investing. It’s easy to focus on short-term fluctuations in stock markets, especially when they make big news headlines. But that means you may miss the fact that over the long term there’s an opportunity to ride out these bumps and give your money a better chance of beating inflation. There are no guarantees though.

Every year, most Junior ISAs being paid into are cash accounts, because parents are worried about the risks associated with investment. 

Sometimes cash can be the right choice, for example, if the money is needed for something specific that is a couple of years away. This could be the case if the child is an older teenager doing A-levels and needs the money for university costs. 

But if the child is a baby or very young, you’re putting aside money for the long term, possibly up to 18 years. That type of time-frame means you really should consider investments, which can grow your money more than cash. 

How does risk tolerance impact the investments I choose?

Risk tolerance is often measured on a scale of 1-7 or 1-10 with one being the lowest risk tolerance and 7 or 10 being the highest. In reality most people end up somewhere near the middle, say a 4/7 or a 6/10. But what does this mean for the investments that you opt for? Well, the higher the score the more you’ll have in shares and less you’ll have in lower risk investments such as bonds. 

This is called asset allocation and it is one of the key ways to increase or reduce your risk. It refers to the way your money is divided between different types of investments, such as cash, bonds and shares. A high-risk portfolio might have 80% in shares and 20% in bonds, while a low-risk portfolio might be the opposite. A balanced portfolio for an average risk investor is usually 60% shares and 40% bonds. The idea is that different assets will rise and fall at different times. So if your shares are falling, bonds may not, and this will smooth out the rises and falls for your money, making it less volatile in the jargon. 

How do I reduce the risk in my portfolio?

The key here is to make your portfolio well diversified so you don’t have all your eggs in one basket. This means that you spread your shares and bonds investments between different sizes of company, different sectors such as consumer businesses, industrials and financials and various regions around the world – not just the UK and US, for example, but Europe, Japan and other stock markets too. 

If you invest in a professionally managed global fund, this will do the diversification for you. And you can also choose a multi-asset fund that does the asset allocation for you too.  

But once you start investing you need to accept that over the short-term the value of your investments is very likely to rise and fall. The key is to make sure that you are happy with the amount of exposure you have to shares, that your portfolio is well-diversified, and then to commit to holding the investments for the long term – at least five years.