Life is all about taking risks, so also saving and investing involves several risks. For smart investors, the magic is to find a middle ground between these different risks.
The risk that an institution will fail in its obligations (default risk), risk that the money will not keep up with rising prices (inflation risk), the risk that comes with share prices going up and down (volatility risk), the risk that you could have earned better returns elsewhere (interest-rate risk)
However, what is a good balance differs from one investor to another. The personal attitude to risk, investment goals, time frame and need for returns, personal circumstances – how much you can afford to lose (your capacity for loss) are some questions every investor must answer before making an investment decision.
All these questions make up what is called individual ‘risk appetite’. Over the years, a good way to mitigate risk is to spread your money across a range of different investment types.
Ask yourself what would happen if I lose some or all of the money I am putting into this investment. This will depend largely on your circumstances and how much of your money you are investing.
Saving and investing choices will depend on goals and timescales. The bigger your goal in relation to the assets or income you wish to invest, the greater the rate of return required to beat inflation and hit your goal. Taking no volatility risk at all might make your goals impossible to achieve, taking too much might lose you your investment.
If I have a short-term goal my appetite for volatility risk would usually be low and cash products will be the best place to invest. You don’t want to be worrying about the state of the financial markets when you need your money to be readily accessible.
Short-term goals (under five years) such as a car or a house deposit are best saved for in cash. However, cash savings run the risk of not keeping up with rising prices (inflation risk)
With longer-term goals, it’s more advisable to put cash into investments that have a better chance of giving inflation-beating returns, such as shares, but which carry the risk of prices going down.
Longer time frame gives the investment more time to recover if it falls in value. So if you have a long-term goal it makes sense to be prepared to take on volatility risk for the opportunity of higher returns. However, as a long-term goal moves closer the risk balance should change.
Risk attitude is subjective and is likely to be influenced by current events or recent experiences. When stock markets rally, we tend to feel comfortable with market risk, when they are falling we do not. On the other hand, we might regret it if we’ve been very cautious and our long term investments don’t produce the returns we need.
You can keep risks in line with your risk appetite by spreading cash across a range of different investments.
