How much risk should you take when investing?

Let’s talk about attitude to risk when investing for your long-term future.

It’s an important aspect – perhaps the most important. Taking too much or not enough can determine whether you reach your financial goals or fall short.

When we discuss risk, what we really mean is volatility. To unpack the jargon here, this means how quickly and to what degree your investment portfolio can change in value.

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Those with a strong appetite for risk will be comfortable with sharp up and down movements, happy to stomach heavy losses for the prospect of big returns. For more risk-averse investors, purely earning some interest on their savings, provided it keeps pace with inflation, is seen as a more than adequate outcome.

This is something commonly referred to as risk vs reward, and it’s a personal thing.

Experienced investors will have a firm grasp of risk and reward and be able to choose suitable investments themselves. But those new to the game may find the task challenging and would benefit from some support.

Let’s examine some things that may come in useful to help you decide how much risk is right for you.

Dispelling some investing myths around risk

As with many things in life, risk is on a scale; it’s not all or nothing. To dispel a couple of myths, there is no such thing as a no-risk investment, while comparisons between investing and gambling are wide of the mark.

For example, sticking cash under your mattress may seem safe but the money could get lost or stolen and you won’t earn any interest to protect against inflation. On the flip side, if you were to hinge your future on a few single company shares, you could lose a hefty chunk of your money even if just one performs poorly.

The steps to establish personal attitude to risk

To get you thinking about the process, it may help to cover how financial planners evaluate personal attitude to risk for their clients. It’s a regulatory requirement for advisers to establish this accurately and recommend suitable investments.

And as someone who worked as a planner for eight years, I can walk you through a typical risk-profiling exercise.

So, the process usually involves several stages. The first is to gather information about your current portfolio and discuss your understanding and knowledge of what you’re invested in. This is part of what’s called fact finding. If you have no investment experience, a discussion still takes place to gauge how much you know.

Next, the planner will ask you to fill out an electronic questionnaire (in some cases they’ll go through it with you). These questionnaires normally involve around 10 statements to which you respond by saying whether you either strongly agree, agree, are neutral, disagree, or strongly disagree.

A common question might be: “When investing, are you excited by the potential gains or nervous about the possible losses?”

• Finding out your risk score

Once you’ve completed the questionnaire, you’re provided with a risk score which will commonly fall into one of five levels or categories. These are: low, medium-low, medium, medium-high, high.

Some advice firms may opt for alternative terms such as cautious, cautious-balanced, balanced, balanced-adventurous, adventurous. But these are purely the same things badged-up with different words. I prefer the former as it’s easier to understand.

So, what could you expect to invest in based on your risk score?

The two main assets used in portfolio construction are stocks & shares and bonds. Shares usually carry more risk, bonds less. As such, when you move up the risk scale, weightings to shares increase and bond allocations reduce.

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For instance, a low-medium risk investor’s portfolio may have 40% in stocks and shares and 60% in bonds, while a medium-high risk investor may have close to 100% in the stock market. A useful way to increase risk, and the potential rewards that come with it, is to invest in smaller company shares or emerging markets.

While tolerance for investment ups and downs is a personal thing, the need to mitigate risk through diversification should apply to all. This means investing in lots of different companies in various parts of the world.

The personalisation bit comes in when you decide how much to allocate to certain assets.

• When to deviate from your risk score

A further, more in-depth discussion will now take place to ascertain a couple of things. The first is whether you feel the score is accurate.

Let’s say the risk-profiling report determines that your personal risk level is medium-high. The planner will then walk you through the level of ups and downs you might expect.

If you’re comfortable with the potential fluctuations, and if this is in-line with how you’ve invested in the past, you and the adviser can agree the assessment is fair and suitable investments can be recommended.

The second thing is that, even if you agree with the overall assessment, you may not feel the level of risk is appropriate for the specific goal you’re investing for. To expand, in certain circumstances it can make sense to deviate either higher or lower.

A key part of this, and something that runs adjacent to risk appetite, is capacity for loss. What this means is that, while you might be happy with the possibility of losing lots of money, you must be able to afford to.

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To illustrate: someone in their 20s may agree that their risk score is medium. But for their retirement savings they may opt for more risk as the money will be invested for several decades - or perhaps even longer if they choose to keep their savings invested in retirement and draw flexible income.

Given the investor’s long time frame, and the fact they can’t access pension savings until age 55 (rising to 57 in 2028), their capacity for loss may be greater. In addition, if they pay into their pension every month, periods where markets fall will enable them to buy stocks at cheaper prices – something known in industry speak as pound cost averaging.

Conversely, if the client is typically a high-risk investor but the time frame for a certain goal is fairly short, they may not feel comfortable sticking the whole lot in stocks and shares.

For instance, if they have a child who will hit age 18 in five years’ time and are investing in ISAs to support them through university, they may wish to include some more cautious investments, such as bonds, too.

As you may have noted, one of the core factors here is time. As a rule of thumb, the further you are from your financial goal, the more risk you can take.

One thing you may wonder is whether your approach to risk should differ between tax wrappers such as individual savings accounts (ISA) and self-invested personal pensions (SIPP).

Well, the short answer is no. That said, as you tend to invest in your pension for longer periods, it can sometimes be prudent to take more risk with your retirement savings than with your ISA as you have more time to ride out stock market falls.

Where to turn if you need some help

As mentioned previously, some people are capable and confident enough to choose investments to suit their risk appetite, whereas others need some help. And regulated financial advice, while helpful, isn’t necessarily available for everyone – especially if the amount you have to invest is modest.

To support investors who want help selecting suitable investments, because they lack either confidence or time, we at interactive investor have developed and launched the Managed ISA.

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Like the risk-profiling questionnaire I undertook with my clients back in the day, when you apply for the Managed ISA, you'll answer a few questions to determine the level of risk you’re comfortable with. Once this has been established, interactive investor matches you to the most suitable investment portfolio.

Once that's done, check you're happy, open your ISA - then it's over to the experts who manage the money on your behalf.

But let’s say you want to pick your own investments with some of your money. You can do that too, and within the same product. There’s no need to open two ISAs - one for managed investments and another for those you self-select - keeping things nice and simple.