Understanding risk

Before making any investment decision, it’s good to identify how much risk you’re comfortable taking (your risk tolerance).


If your financial goal calls for high potential returns, you’ll probably have to take more risk. If your goal seems more in reach when you decide to invest, you can take less risk. This will also depend on your time horizon, the length of time you have to reach your goals.

Goals

 If you have short term goals (1-5 years), it may be best to use any savings you currently have, put aside some of your income or reduce your spending and put any excess into a savings account. The interest rate can be low but you don’t run the risk of losing your money.


For any medium (5-10 years) or longer-term goals (10+ years), you may decide to be a bit more adventurous. For example, investing in multi-index funds can offer you higher potential rewards and you’ll have more time to make up any losses if the value of your investment dips.


Depending on how much you need to reach a goal, you can choose to invest in lower-risk funds with lower potential returns or riskier funds with more potential reward but more chance of loss.

Risk tolerance

How much uncertainty can you handle? Are you comfortable with investments that fluctuate up and down in value? If so, you’re risk tolerant.


If you’re not comfortable to see a drop at all, you’re probably risk averse. Your tolerance is slightly higher if you feel you can make up for short-term losses by being patient and waiting for your investment to improve.

Time horizon

This is the length of time you need to stay invested to reach your goal. If you don’t need the money for years to come, you may feel you can take a greater risk with your investments as there’s more time to make up for any losses.


As your goals get closer your time horizon gets shorter, so you should constantly review your risk capacity and risk tolerance. In general, the shorter your horizon, the less risk you’ll be willing to take as you’ll want to preserve the total value of your stocks and shares ISA or pension.