Investment risk explained

Good long-term investing begins with assessing your
attitude to risk, your financial goals and how long you have
to get there.

Figuring out the relationship between these three elements will help you decide what to invest in. In this sense, risk goes a long way to informing what your portfolio will look like.

For example, if your investment goal is a £25,000 house deposit and you are giving yourself five years to get there with an initial lump sum of £20,000, you’d need to generate a 25% return over those five years.

If you were to lengthen the timeframe or reduce that goal, you’d put less pressure on your portfolio to produce
those returns.

The result would be that you’d expect to hold higher risk assets in the first instance, because your goals require the potential for high reward (and risk and possible reward go hand in hand). Reducing the need to generate that level of return means you could afford to adopt a lower risk level and can choose assets potentially offering less of a reward.

This is a crude example but the point is we should always start with these three elements and work backwards to choose the assets we invest in. If your goals look overly ambitious and you aren’t comfortable exposing your money to the risk level you’d need to take in the hope of getting there, it’s much better to decide that from the outset.

This is the big trade-off every investor needs to understand when they start investing.