Striking the right balance between risk and return can be a struggle for even the most experienced investor.

Taking on some risk is essential if you want to grow your money, but this doesn’t mean you have to endure sleepless nights worrying about losses.

What is risk?

When people talk about risk they’re usually referring to market risk. Investing in the stock market can be risky because uncontrollable events like an economic downturn, political upheaval or a natural disaster can cause large price swings.

Market risk varies depending on what you invest in. Emerging markets, for example, are considered riskier than developed markets.

There are other risks to consider, such as currency risk – the risk of losing money from fluctuating exchange rates; and longevity risk – the risk that you’ll outlive your savings.

Why do I need risk?

Interest rates on cash-based savings are so low that if you want to grow your money you need to take on market risk.

‘The rule of thumb is that the more risk you take, the higher the potential return should be. While equities are seen as the highest-risk traditional investment, they have over the very long term delivered the strongest returns,’ says Ryan Hughes, head of fund selection at AJ Bell Youinvest.

UK equities have beaten cash in nine out of 10 rolling 10-year periods since 1899. Over rolling 18-year periods, equities have outperformed 99% of the time, according to the Barclays Equity Gilt study.

‘If you think back on all the things that have happened since 1899 you can see how remarkably resilient and adaptable good companies are. So we would expect equities to form the largest proportion of most portfolios for 20 to 40 year-olds,’ says James Horniman, a portfolio manager at financial services group James Hambro & Partners.

Are other assets risky?

Stocks have traditionally been viewed as riskier than bonds and cash, but this isn’t necessarily the case right now as inflation is rising.

Artemis’s Simon Edelsten, who manages Mid-Wynd International Investment Trust (MWY), comments: ‘Traditionally equities have been riskier than bonds, but over the long term they have delivered superior returns. Higher inflation is always a problem for bonds, especially when yields are very low, while companies with good pricing power can often raise prices to cope with higher costs.’

Cash savings accounts aren’t risk-free either. Inflation is currently higher than the interest on deposit-based savings, which means you’re actually losing money in real terms.

How much risk should I take on?

Your capacity for risk will depend on your individual circumstances. A good starting point is to work out your investment time horizon – in general, the longer you’re investing for, the more risk you can consider taking.

If you’re a 20 year-old saving for your retirement you can afford to take on a high level of risk because your investment time horizon is around 40 years. But if you’re saving to buy a house in five years’ time, your risk appetite would be lower. This is because you have less time to ride out market volatility.

People used to be told to reduce their investment risk as they approached retirement, but this thinking has changed in recent times.

‘A 60 year-old who has just retired might need to generate an income from their investments that should last over 20 years, assuming normal life expectancy,’ says AJ Bell’s Ryan Hughes. ‘To keep up with inflation they will have to take an element of risk that is likely to include some investment in equities.’

There are other factors to consider. Adrian Lowcock, investment manager at financial services group Architas, points out that a millionaire’s lifestyle is less likely to be impacted by the loss of £10,000 than someone who only has £100,000.

‘Capacity for loss assesses someone’s ability to recover from that loss and the impact such a loss would have on them,’ he adds.

How do I manage risk?

One of the best ways to manage risk is to build a diversified portfolio. You can spread your money across different assets, such as equities, bonds, property, gold and cash, as well as different sectors, geographies and company sizes.

‘The key is to get assets that are not closely correlated to one another; i.e. they don’t go up or down at the same time. Then you also need to rebalance the portfolio, periodically taking profits in the asset class which is performing (the best) and reallocating to those lagging. This helps you lock in gains,’ explains Lowcock.

Falling share prices can be unnerving so it’s wise to take a long-term view. Peter Chadborn, director at financial adviser Plan Money, says viewing investment behaviours over the short-term will make volatility appear worse than it is and cause unnecessary anxiety.

‘We are firm believers in the well-worn investment phrase: time in the market, not timing the market. Very few people, professional or otherwise, have the proven ability to make consistently accurate market-timing calls and even when they do, one bad call can undermine all the good ones,’ he says.

If you don’t want to choose investments yourself, you could opt for a ‘one-stop-shop’ multi-asset fund which invests across lots of different assets, sectors and regions. There are lots of versions catering for different risk profiles. (EP)

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