Want to invest? First understand investment risk and reward

When you want to start investing, there are a number of questions you’ll need to answer. One of these is what to invest in?

Consider that the market will always have ups and downs. How much can movement you stomach?

Answering these questions requires an understanding of investment risk and reward. Secondly, you need to determine your own level of risk tolerance for your investments.

In this article, we’ll talk about investment risk and reward, and how you can manage investment risk. We’ll also explain how low-risk, high-return investments can be a great way to achieve your financial goals.

What do we mean by “investment risk and rewards”?

Before we get started, let’s first define some key terms.

Investment Risk: The risk of loss associated with an investment.
Let’s say that you decide to invest in a stock. This has a risk of loss as the price of the stock could go down. This risk of loss comes from a number of factors, including the company’s financial stability, the market conditions, and the individual factors involved in the stock.

Investment Reward: The amount of return that an investment provides.
In contrast, a stock that is going up in value has a reward associated with it. This reward can be through increase in value of the stock from when you bought it. If you sell the stock you profit from the increased value (known as capital gains).

Another way you can receive financial reward from your investments is by being paid out quarterly/annually dividends.

When you make an investment, you are taking on the potential for both risk and reward. It is important to be aware of these risks and rewards before making any investment decisions. This will help you make informed decisions that should lead to a higher return on your investments.

How risky is investing?

The level of risk associated with any given investment will vary, so there’s no one answer.

Broadly speaking, investments can be considered to be risky if they offer a potential for high returns but also high risk of losses.

The risks and rewards of common types of investment assets

1. Equities

Stocks in particular companies

Shares in individual companies are perhaps what first comes to mind when you think of investing.

Stocks and shares are fractions of ownership of a company. Investing in one particular company is generally considered to be a risky investment because it offers the potential for significant returns (often in the form of capital gains – ie. price increases) but also the potential for significant losses if the stock market declines (ie. price decreases).

Buying shares in one particular company is the riskiest type of stock investment, as the return depends entirely on the performance of that company.

This type of investment is a form of active investing. You need to know what you’re doing to attempt this kind of investment. There’s an element of timing the market – you’ll have to monitor how the stock’s doing and try to analyse when to buy or sell.

Funds and ETFs

A common way to invest in stocks/shares is through a fund. This is less risky than the previous option as a fund invests in a range of different companies. Instead of owning a slice of one company, you own a smaller slice of multiple companies. For example, you could invest in a FTSE100 fund meaning you’d have a small share in the companies that make up the FTSE100.

This spreads the risk of one company performing badly, and you share the burden with other investors.

There are different types of funds – mutual funds and exchange-traded funds (ETFs) being the most commonly used by the average investor. As equities, these are still risky assets but different funds come with different risk levels. On the whole, they are much less risky than stocks in individual companies.

These investments can be passive, where the fund’s investment choices are set in advance, or active where a fund manager tries to buy shares in the individual companies in that fund at the right time to outperform the market. Active funds come with higher fees for this service.

2. Bonds

In contrast, bonds (which are typically issued by governments or other organisations with a long-term credit rating) are generally considered to be relatively safe investments. You effectively loan your money for a fixed period (often 5, 10 or 15 years) and they guarantee you’ll get your money back at the end of the bond period, plus a bit of interest. This interest is how you earn money with bonds.

Bonds tend to have a much lower return on your original investment than stocks. However, they are far less risky and tend to provide stability and protection against inflation.

3. Cash and Gold

Some people invest in gold as a hedge against inflation or keep part of their portfolio in cash. You’ll get very little return on these, but they are stable in the event of a market crash.

Cash, however, loses value as inflation rises. So while it’s safe, your money ends up worth less.

4. Property

By investing in property, we’re talking about buy-to-let properties or investing in commercial property (often through a kind of fund). Investing in property doesn’t include the home you live in. A lot of people mistakenly think that their house is an asset, but your home shouldn’t be counted as one of your investments.

The housing market has peaks and troughs just like other types of investments. Homes can increase and decrease in value. This means you face the risk of losing money if the value of the property falls and you want or need to sell.

5. Cryptocurrencies

Bitcoin is a digital currency created in 2008. Since then, the price has gone up and down dramatically and frequently. It is considered as volatile, so it’s a risky investment.

There are many controversies around Bitcoin, from the amount of electricity needed for Bitcoin mining, to through to the fact that the currency anonymity is attractive to money launderers. For a time Tesla accepted payment in Bitcoin, backtracking just months later.

Ether is the second largest cryptocurrency. It’s often referred to as Ethereum (which is actually the system, not the currency). There are similar concerns about energy use.

Another risk factor worth mentioning is the risk of losing your key to access your Bitcoin. This access code must be kept safe. You could lose everything by accident by keeping your key on USB and losing that, or if your hard drive dies on you.

Do I need to invest in all of these?

No. Many investors choose a simple investment portfolio with two types of investment – riskier equities and safer bonds. Some people add a small amount (eg. 5% or less) of very risky, active investments like individual company stocks or cryptocurrency.

A key question then, is what proportion of each should you invest in? We’ll get to that later in this article.

And what about investment rewards?

That was a lot about risk. So what about potential rewards? In fact, risk and reward are two sides of the same coin. Riskier investments are more likely to produce higher rewards. But they are also more likely to cause losses.

When choosing what to invest in, you should consider if the potential reward is worth the risk.

Investment rewards come in two forms – increases in value and dividends. You can read more about those forms of reward in this article – How to Make Money in the Stock Market.

How to determine your investment risk and reward appetite

So how can you figure out your risk and reward tolerance levels so you can decide what to invest in?

3 questions to help you understand your investment risk tolerance

Your answers to the following questions can help you determine your investment risk tolerance:

1. How far away from retirement are you?

It’s important to consider how long you plan to hold your investments. The longer that time period is, the more chance there is to recover from dips in the market which lower the value of your investments.

If the market dips in 2023 but you’re not retiring for another 15 years, then it doesn’t really matter that the market dips in 2023. You won’t be selling your investments, so it’s irrelevant.

This is one reason why it’s good to automate your investments and leave them be. The more you check the current value, the more anxiety you cause for yourself.

In short, the further away you are from retirement, the more risk you could consider taking in your investments. And conversely, the nearer you are to retirement, the more you may wish to go for conservative investments.

2. How much volatility do you feel comfortable with in your portfolio?

What if the markets crash tomorrow and take a while to recover? How big of a loss can you tolerate before you panic or feel sick with worry?

What if your investments were to drop 20% in value? 50%? How much loss could you tolerate short-term? Play around with the figures and pay attention to the feeling in your gut. Can you keep calm, hold onto your assets and wait for the market to recover?

Worry is real when the market dips. Some people panic and sell at a low price because they’re scared the market will drop further. However, the best thing to do is hold onto your investments (or even invest more) and wait for the market to recover.

Some people need to balance riskier assets with conservative ones (like bonds) to help them keep their cool in this situation. That’s fine – you just have to work out what you personally are comfortable with.

Once you know how much loss in value you could tolerate in a market downturn, you can start to think about how much risk is acceptable for your portfolio.

Some people, regardless of how much they’re worth, will say “no problem, let’s go for it”. While others will carefully evaluate their financial worth and be willing to risk only a certain percentage of their overall wealth.

It is ultimately up to each individual investor to decide how much risk they are comfortable taking on board. Your fears and your likely reactions to market dips need to be considered when deciding your risk tolerance. If you are likely to lie awake at night worrying, you may choose to hold more conservative assets to balance out the riskier investments.

3. How much money are you comfortable locking away?

If you think about your investments as being locked away, it’s easier to take on risk.

The money you hold in investments should not be money you need in the near future.

Before you go opening a Stocks & Shares ISA, you want to make sure you have a cash buffer. You don’t want to have to sell your investments in an emergency.

If you’re forced to sell, you might have to sell at a loss if the price is down when you need the money.

Final word on investment risk and reward

No matter which method you use to determine your investment risk and reward tolerance, remember that no investment is guaranteed and there is always potential for loss. It’s important to have a plan for dealing with losses (mentally as much as practically) and making sure that your overall investment strategy meets your goals and financial needs.

It’s wise to know your level of investment risk tolerance before you start investing. Because investments are so integral to you and your family’s financial future, it’s important you be intimately connected with your gut feelings, your ideas about investing your money and the risks involved.

By seriously considering the above questions and your responses, you’ll be able to determine your risk tolerance for investing and choose a suitable investment portfolio that matches your comfort levels.

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