How to assess your risk profile
Here are the main factors that you should consider when deciding how much risk to take:-
- For how long are you planning on leaving this investment before you touch it?
- How important will this money be to your overall financial situation and what capacity do you have to suffer losses?
- To what extent is your future wealth connected to the future state of the economy?
- How much experience and understanding of investments do you have?
- Are you ambitious or more conservative?
- Just how much volatility can you live with?
If we look at these points in turn....
The longer the term, the more time you have for the ups and downs of higher risk investments to work in your favour. Remember that higher risk investments tend to produce higher returns, but are more volatile than more cautious investments.
The importance of the money
To use an extreme example, you probably won't mind losing £1.00 on the Grand National, but you wouldn't bet your house on it. The extent to which you can afford to lose money should guide you towards how much risk you are in a position to take.
Correlation with the general economy
If your income from work depends on the British or World economy being strong, then it is important that your investments do well if the economy struggles, because you might need to fall back on them during difficult times. In other words, it can be advisable to take less risk with your investments if your business income is closely correlated to the world economy and to the stock market in particular.
Experience and knowledge
I tend to encourage novice investors to err on the side of caution, but those clients who have seen their money rise and fall on stock markets before are more likely to be sufficiently patient to persevere until their investments enjoy a good run.
What you need your money to achieve, i.e. how ambitious do you need to be?
You might need to take risk to enable your money to achieve the growth that will lead to you having a comfortable standard of living. On the other hand, you might be in a comfortable position already and just need to retain your current purchasing power.
Volatility and a nervous disposition
This is perhaps the most important point of all. Riskier investments have good times and bad times and no one knows when they will arise. You have to be able to hold your nerve during the bad times, because if you panic and sell, you will realise losses. It is common for bad periods to be followed by a strong recovery, e.g. the 2008 credit crunch followed by strong returns in 2009 and 2010, but if you bailed out at the end of 2008, because you couldn't bear to lose any more money, then not only would you have suffered losses, but you would have missed out on the recovery. It is therefore wise to only take the level of risk that won't cause you to panic-sell during the bad times, so that you benefit from the recovery.
Further help assessing your risk
If you come to me for advice, I will provide you with a spreadsheet that shows you my various portfolios, ranging from "very cautious" to "adventurous" and this document explains the level of risk to your capital with each of these portfolios.