"If you want a guarantee, buy a toaster."
A proper understanding of risk lies at the very heart of successful investing and there are countless books on the subject.
The response to any risk is determined by an individual’s personality and by their understanding of the risk. Most people’s initial response to a risk will be an emotional one and, the more unfamiliar the situation, the more extreme the response will be.
For example, there are plenty of people who will not go near the stock market because they are worried about the risk of losing money. Yet those same people will happily consider a “buy to let” investment property. Both are long-term investments which may rise or fall in value but many people favour property simply because they feel that they understand it better.
Then there are those who keep their money in the banks and building societies for no other reason than it is “risk-free”. But is it really? How long does it take for inflation to nibble away at the value of cash like a mouse in the pantry?
An important point is that you should never take risk unless you need to or you want to. You may need to accept risk to protect your capital from inflation. You may want to accept risk simply because you enjoy the thrill. So what are the main risks to consider and how should you approach them:
Losing money: Investments may rise or fall in value. You need to consider what losses you are actually able (and willing) to accept in the worst case. Choose investments that will fluctuate within acceptable levels. Spread your risk (diversify) and make sure that you are investing for long enough to ride out the bad times. Investments are for the longer term, by which we mean 5-10 years and longer.
Inflation: Inflation of just 2.5% per annum will halve the spending power of your money over a 25 year period. For most people the main purpose of an investment is to grow their capital faster than inflation, to increase its spending power.
Liquidity: Don’t invest or “tie up” money that you need to access in the short term. If you are forced to sell (shares or property) when markets are depressed you may have to accept rock-bottom prices or, in the most extreme case, you may not be able to sell at all.
Emotion: Investors are often their own worst enemy. Making decisions based solely on emotion can be the biggest risk of all, e.g.
Frequent buying and selling, trying to double guess the market.
Panic selling. We know the markets can fall but we don’t like it.
Panic buying. The markets are rising, we don’t want to miss out.
Chasing rainbows. It did well last year so it’s bound to do well this year.
Doing nothing. Head in the sand.
And like the man said – if you want a guarantee, buy a toaster! (Clint Eastwood – apparently.)