Learn About Investing
Your attitude to risk is central in answering this question. Most significantly, there is a difference between your personal appetite for taking risks and your capacity to bear risk.
A billionaire can afford to make a few risky investments. After all, losing a couple of million here or there wouldn’t be too awful for a billionaire. They might choose to make a risky investment even if they’re cautious by nature. A teenager may love taking risks, but is unlikely to have much financial capacity to back this up.
The upshot is that a balance needs to be struck between your financial capacity to bear risks and your personal appetite for taking them. This applies whether you’re totally gung-ho or supremely cautious.
So, what’s my risk capacity?
A number of factors are involved and it isn’t just about how much money you are ‘safely’ able to lose before your situation starts looking really grim. A few things to bear in mind:
- First off, you might want to check if you should be investing in the first place
- The strength of your financial safety nets. (Spare cash at hand for emergencies etc)
- How long you’ll be investing, otherwise known as your ‘time horizon’. This is significant because risk is related to volatility. Your age is likely to be an important factor here.
- How important it is to you whether, or not, your financial goals are met
- How secure you are in your job…or not
This list is far from exhaustive, but does at least provide a few examples of questions to ask yourself when reflecting on your capacity to absorb risks associated with investing.
It is possible that your risk appetite and capacity may be mismatched. For example, it is common for people with low risk appetite to opt for low risk, low return investments when they actually have capacity to absorb more risk. While it is perfectly understandable that many people are not comfortable with the idea of losing money, being overly cautious may cause regret if your long term investments don’t product the returns you need.
Matching risk capacity and appetite with suitable investments
Having established your risk appetite and capacity, it’s possible to select investments that are suited to this risk profile. It won’t be the same for everyone.
Some types of assets are riskier than others, which is because they are more volatile. For example, it’s not uncommon to see sharp declines – as well as rises – in the value of shares, especially over the short term. If you’re only investing for a couple of years, this means you could want to get your money back when markets are at a low point. If you can’t afford to wait, you could be forced to sell up at a loss.
Common rule-of-thumb advice is that shares are an appropriate investment over periods of five years, ideally longer. ‘Moderate risk’ products, such as bonds, should be invested for at least three years. If you’re intending to get your money out sooner than that, it’s usually recommended that you stick to cash savings.
While volatility is an important issue when picking the right mix of investments to suit your needs, it certainly isn’t the only one. Nor is your risk profile the only angle that needs to be considered. Your tax situation and more besides should be factored in. That said, a keen appreciation of risk tolerance is widely regarded as a key attribute for successful investors.
What the difference is—and how you can help mend fences.