Investing fundamentals #2 – Understand risk

In the second of a series of blogs about the ten fundamentals of investing, I describe the importance of understanding investment risk.

Investing money is all about risk. By taking more risk with your money, you have the potential to get bigger returns. You also have the potential to lose more money and see it fluctuate in value to a greater extent, a concept known as volatility.

With less risk comes less potential for reward, but also less risk of capital loss or volatility. This relationship between risk, reward and volatility is unbreakable. Investments which claim otherwise are often a shortcut to disaster.

Before investing money, you need to spend some time considering your own attitude towards investment risk. How much risk you are prepared to take is an important part of your investment decisions.

Because we all have different attitudes towards investment risk, as well as different levels of knowledge and experience, it is important to invest in a way consistent with your individual attitudes towards investment risk, rather than allow yourself to be pigeon-holed into a broad but essentially meaningless risk category such as ‘cautious’ or ‘balanced’.

As well as the amount of investment risk you are prepared to take, also consider how much risk you need to take (see the previous page of this guide) and how much risk you are able to take, sometimes referred to as your ‘capacity for loss’.

If you can’t afford to lose the money you are investing, consider very carefully the nature of the investments you are selecting. All investments can go down as well as up in value. Your capacity for loss should inform whether you can afford to expose your money to those investment types more likely to fall in value, such as company shares (equities).

Read about all ten investing fundamentals by downloading our free guide:

The Investing Fundamentals Guide 2014