In spite of all the media headlines surrounding the Bank of England’s decision to raise interest rates, the fact was that the raise was only 0.25% and that it brought the base rate up to just 0.75%. Even assuming that banks passed on the rise in full to both borrowers and savers, it still isn’t exactly a huge gain for the former (although it could cause a lot of pain for the latter). While there is often a case for keeping some cash savings easily accessible if only as an emergency fund, there is also often a case for risking some money in the stock market in the hope of much better returns.
How much money should you risk?
The value of investments can go down as well as up and there is no guarantee that you will get your capital back. Therefore you should be very clear about the fact that investment funds should be funds which you can afford to lose. You can minimize the risk of losing all of your investment capital by diversifying and balancing your portfolio, but in principle, the entirety of your investment funds are at risk.
How much risk should you take?
There is no right or wrong answer here, however there are some pointers to take into consideration.
The level of reward should reflect the level of risk
Let’s take two hypothetical investments. One has a 50% risk of capital loss and offers a potential return of 1%. The other has a 75% risk of capital loss and offers a potential return of 50%. While neither investment might be right for you, it is clear that the second investment has a much better ratio of risk to reward and so even although the risk of capital loss is higher, it is still a far more attractive option.
Time is a great healer for investment portfolios
People invest for a reason, for example to build an income for retirement. The longer you have to reach your investment goals, the more risks you can afford to take along the way. For example if you lose all your investment capital at age 25, you still have about 40 years in which to rebuild it, whereas if you lose all your investment capital aged 60, then you have a much shorter time frame in which to rebuild it. That is not to say that younger investors should automatically put all their investment capital into riskier investments or that older investors should stay away from risk, it’s just a factor to remember when taking investment decisions.
Excessive risk avoidance can also be dangerous to your financial health
Time, tide and inflation wait for no man and the latter can eat away at cash savings with the result that they reduce in effective value. Only investments which offer a net return which stays at least on a par with inflation can be said to be truly growing.
Once you have decided how much risk you are prepared to take, remember that it is effectively a limit, not a target. Your goal should always be to find the investments which offer the best value for money and, of those, to select the very best for your portfolio. You may find that you can achieve your investment goals without actually purchasing investments at your maximum risk level, in which case you can either take the safe route of minimising risk or put some of your investment capital into investments which have both greater risk and greater potential reward to see if you can exceed the investment targets you set yourself.
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