Your risk tolerance is the level of uncertainty and losses you are willing to accept in order to achieve a higher potential return. So, understanding your risk tolerance is an important part of investing.

Taking on too much risk can lead to financial stress and sleepless nights, while taking on too little risk may mean sacrificing potential returns. By understanding your risk tolerance, you can make sure your investments are in line with your personal goals and preferences.

Find out more in this week’s podcast. (If you would prefer to read about it, there’s also a transcript below).

Transcript

In today’s episode, we are going to look at risk tolerance, which is such an important part of the investment decision process, because there’s no single answer to the question of ‘How much investment risk you should take on?’ It very much depends on your individual circumstances, goals, and comfort level with risk.

Some people are more comfortable with risk than others.

Some people are willing to take on more risk in order to achieve their goals and some people have different tolerance for different types of risk. Understanding, investment risk, and determining what level of risk you feel comfortable with before you invest is an important part of any investment decision, and mustn’t be underestimated.

Your potential returns available from different kinds of investment and the risk involved change over time as a result of economic, political, and regulatory developments, as well as a host of other factors.

There are few different ways to think about risk tolerance.

One way is to consider; How you would feel if your investments lost money in the short term?

If the thought of seeing your account balance go down makes you anxious, you may be risk averse, but let’s look at the other factors involved in determining your risk tolerance.

Volatile Investments

And the first is volatile investments.

If you are comfortable with the idea of short term losses in exchange for potential for long term gains, you may be willing to take on more risk. Another way to think about risk tolerance is to consider how much volatility you are comfortable with.

Volatility is a measure of how much prices fluctuate over time. Investments that are more volatile will have bigger ups and downs in a value, while less volatile investments will have slower steadier prices increases.

Stability and Growth

But what about stability and slower growth?

Some investors are attracted to the potential for big gains from investments that are more volatile, while others prefer investments that offer stability and slower growth. So understanding your risk tolerance can help you make better investment decisions. It can also help you avoid taking on too much risk, or the opposite is true, that is not taking on enough risk to achieve your goals.

Your investment goals and time scales will also influence how much risk you are willing to take.

What you come up with is your own risk profile.

Type Of Investment

There are also different types of investments which attract different types of risk.

And none of us like to take risk with money. But the reality is there is no such thing as a no risk investment.

You’re always taking on some risk when you invest.

For example; funds that hold bonds tend to be less risky than those that hold shares, but there are always exceptions.

  • What about losing value in real terms?
No such thing as a no risk invesment quote

Well, the money you place in security deposits such as savings accounts, risk losing value in real terms, which is the buying power over time.This is because the interest rate paid won’t always keep up with rising prices, which is inflation. On the other hand index linked investments that follow the rate of inflation, don’t always follow market interest rates. This means that if inflation falls, you could earn less in interest than you expected.

  • And what about inflation and interest rates over time?
    Stock market investments might beat inflation and interest rates over time, but you run the risk that prices might be low at the time you need to sell. And if that is the case, this could result in a poor return. Or if the prices are lower than you bought your investments, then you risk of losing money.

It’s impossible to escape risk completely, but you can manage it by diversifying investments over the long term. You can also look at paying money into your investments on a regular basis, rather than all in one go. This can help smooth out the highs and lows and cut the risk of making big losses.

Capital Risk

Another type of risk is capital risk.

Your investments can go down in value and you may not get back what you invested. Investing in the stock market is normally through shares, which is equities either directly or via funds. The stock market will fluctuate in value every day, sometimes by large amounts and sometimes by small amounts,

You could lose some or all of your money, depending on the company or companies you have bought.

Other assets, such as property and bonds can also fall in value, so they’re not immune from risk themselves.

Inflation Risk

Then there’s inflation risk

The purchasing power of your savings declines, even if your investment increases in value. You may not be making money in real terms if the things that you want to buy with the money you have increased in price faster than your investments.

Cash deposit with low returns may expose you to inflation risk. And we are seeing that at the moment.

Credit Risk

There’s also credit risk.

Credit risk is a risk of not achieving a financial reward due to a borrower’s failure to repay a loan or otherwise meet a contractual obligation. Credit risk is closely tied to the potential return of an investment. The most notable being that yields on bonds can correlate strongly to their perceived credit risk.

Liquidity Risk

Next is liquidity risk.

You are unable to access your money when you want to. Liquidity can be a real risk if you hold assets such as property directly, and also in the bond market where the pool of people who want to buy and sell bonds can dry up.

Currency Risk

And one we’re more familiar with, which is currency risk.

Currency risk is the potential risk of loss from fluctuating foreign exchange rates when investments are exposed to foreign currency, or in foreign currency trading investments.

Interest Rate Risk

And lastly, there’s interest rate risk.

Changes to interest rates affect your returns on savings and investments. Even with a fixed rate, the interest rates in the market may fall below or rise above the fixed rate, affecting your returns relative to rates available elsewhere.

And interest rate risk is a particular risk for bond holders.

In Summary

We all have our own individual risk tolerance, and it’s important to establish what that is, and there are also a number of other factors that affect the risk that we take.

If you would like to help identifying your risk tolerance, get started with a free 30 minute call:

Other related articles:

Rethinking Investment Risk
https://ttwealth.co.uk/rethinking-investment-risk/

Why Understanding Life Expectancy and Longevity Risk Matters
https://ttwealth.co.uk/why-understanding-life-expectancy-longevity-risk-matters/

10 Key Principles of Investments Every Investor Needs To Know
https://ttwealth.co.uk/10-key-principles-of-investments-every-investor-needs-to-know/

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