Why you need to understand financial risk

A lot of people ask me how to start investing. It’s great to see so many people engaging more with investing, but it is important to fully understand the risk first. That’s why this post is going to focus on financial risk.

While stories of people making thousands on the stock market are very common within the personal finance community, less people are willing to discuss their losses. This doesn’t mean they don’t happen however.

No financial decision comes without risk. You should think carefully about the risk and what you are able to afford to lose before making any decisions.

It is important to note this does not constitute financial advice. If you are thinking about making any financial changes you should discuss them with a fully qualified adviser.

In this post I will cover:

  1. What is financial risk?
  2. Why is financial risk important?
  3. How do we categorise risk?
  4. How to establish your own risk tolerance
  5. How to implement your risk tolerance into your investment strategy

What is financial risk?

Financial risk is the possibility of losing money on an investment or business venture. Some more common and distinct financial risks include credit risk, liquidity risk, and operational risk, which refer to specific types of risk.

Essentially, financial risk is a type of danger that can result in the loss of money to interested parties.

Why is financial risk important?

Calculated incorrectly, you could end up losing a lot money and not be able to afford the things you need to. No investment is without risk, but understanding what risk you’re taking on is important.

It also helps you weather storms. If you were invested in high risk funds or stocks, you may well have experienced huge losses in March or April this year. Understanding that this is part of the risk you have taken, will stop you panic selling and therefore missing out on future gains.

A lot of this post is focused on being cautious. But, it’s not all bad news. Understanding your financial risk tolerance may allow you to take on more risk and potentially increase your future returns.

Whether for positive or negative reasons, risk will play a huge part in your finances. Understanding this risk is the first step and will allow you to make the best decisions for you, your family and your finances.

How do we categorise risk?

Frustratingly, most banks and financial institutions categorise risk for investors in slightly different ways. It can be split relatively easily into: low, medium and high risk. Although, firms may call them different names.

While much more complex modelling goes into creating different risk profiles, essentially they refer to how much you might lose and how much you might gain.

High risk investments may well offer the potential for large gains if things go your way, but may also lose you a lot of money if the market crashes or a start-up goes bust for example.

On the other hand, low risk investments will aim to protect you from the major falls of a high risk investment. But, they are not likely to produce as high returns when markets are going well.

How to establish your own risk tolerance

This is an entirely personal decision.

The best thing to do is to talk to your family and loved ones. What is the purpose of your investments and when will you need to draw on them? How much do you need to achieve your goals or live the life you want to?

Once you’ve answered these questions, determining your risk tolerance will be much easier. If you’re in your 20s and saving for your retirement, perhaps you can afford to take more risk as you’ve got plenty of time for markets to recover if there’s a crash.

But, if you’re needing the money sooner, say to buy a house, you might want to take on less risk. Losing a lot of your money in this instant could set back your goals hugely.

If you’re struggling to establish what level of risk to take on, you could speak to a financial adviser. They will be able to use tools like cash flow modelling to show what your situation will look like across a range of scenarios.

How to implement your risk tolerance into your investment strategy

If you have a financial adviser, this is something they will help you with. Depending on the sums, discussing your situation with an adviser can be really beneficial. This is particularly true if you’ve recently experienced a major life event like a divorce or come into money through inheritance.

For those doing it alone, you have a range of options. At a basic level most companies offer a range of funds for different risk appetites. Usually there’s a choice of around four: low risk, medium risk, steady growth, and high risk.

These are not personal to you, so may not fully suit your circumstances. However, if you don’t have particularly complex requests or plans, they’re a good starting option for novice investors.

Another option is to use a robo-adviser. As a retail investor, you won’t get the same service as you would from an adviser. But, on platforms like Nutmeg, you will be asked a few questions about your risk tolerance and some recommendations will be made based on your answers.

So there you have it, why you need to understand financial risk. If you found this post interesting, please like it and share across social media or send it to your friends. I’d also love to hear your thoughts and experiences, so please leave a comment! What do you think about financial risk? Do you think you understand your risk tolerance?

Don’t forget to follow me @Katie20Percent on social media to make sure you don’t miss any of my posts!

One response to “Why you need to understand financial risk”

  1. Hi Katie. I completely agree with you. Establishing your risk tolerance BEFORE you start investing is absolutely vital. Don’t just follow what your friends and work colleagues are doing – your risk tolerance may well be different to theirs. Also, its worth noting that doing nothing and just leaving your money in a bank account that pays a tiny rate of interest is also taking a risk – you risk the possibility that inflation will outstrip the returns on your funds and so, in real terms, they will diminish.

    A quick example of different risk tolerances for different people: Many years ago I was ‘advised’ (and I use the term very loosely!) to invest in a red-hot, triple your money, can’t possibly fail share investment. Obviously I loved the possibility of making massive gains – but I wasn’t prepared to risk much either. I invested £500. A friend of a friend invested the whole of his pension fund! The shares did very well initially but then well and truly tanked. I lost most of the £500 – not ideal but not much in the scheme of things. The other chap lost the whole of his pension fund and rather than retiring at 55 is now looking at working well past state pension age. I couldn’t tolerate the possibility of that happening, he could.

    That said, I do believe that an element of risk is necessary in order to make satisfactory returns. As the great Warren Buffett said “Be fearful when others are greedy … and be greedy when others are fearful.” I’ve invested more money in a range of share funds during the pandemic because I felt that this was a buying opportunity – others may have felt that there is worse to come and so sat tight. Neither approach is right or wrong – you just need to be happy with the risk that you are taking.

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