What is an appropriate level of risk?

In the previous post we saw that low-risk investments are in high demand. Does this mean that low-risk is always the way to go? Should you avoid risk at all costs?

The answer, as in so many things, is that it depends. Mainly, it depends on when you will need the money. If you are close to retirement, having built up a substantial capital sum over many years, the last thing you want is to suffer a capital loss just before you retire, which will reduce the income from your capital just when you need it to live on. So in that situation, you would want your money to be in low-risk investments.

On the other hand, if you are a young person who is decades away from retirement, you don't actually need your capital to live on just yet; you have your salary. So you can afford to take a few risks with your investments, because if you do suffer a capital loss, there is time to make it up before you actually need the income to live on.

And the reason why it would be good to take a risk if you can, was covered in the previous post: higher rewards!

Let's look at an example. Alan is 32, in a high-paying job, contributing 15% of his salary to his employer's pension fund, and has saved up £10,000 in addition to this, for investment. Through a friend he hears about a very high-risk investment opportunity in green energy. There is a potential for a 30% annual return, but also a real risk of losing everything. If Alan invests, and things turn out as expected, his £10,000 will be worth a cool £37,000 in five years' time, a very nice boost to his pension fund savings. If he then switched the funds into his much more low-risk pension fund investment as an additional contribution, it would either allow him to reduce his contributions going forward to get the same income when he retires, or increase his retirement income- and his options on retirement.

If, on the other hand, the investment fails and he loses his £10,000, it's not the end of the world. Certainly it's a blow, but it won't impact his retirement negatively, and he has many more years yet to save up more money for another go. He can afford to take the risk: a person just about to retire, can't.

Within these broad guidelines, of course, everyone has their own attitude to risk. Some people are more risk-averse: the idea of any loss is awful to them, and so they are willing to sacrifice some potential upside to avoid losses. Others are more sanguine, and feel that the odd loss here or there is worth the extra upside. You need to think carefully about your own attitude to risk, and make sure you take it into account when selecting investments, or when talking to your investment adviser.