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Understanding investment risk tolerance

Your risk tolerance refers to how much risk you are comfortable with. A high risk tolerance means you're more comfortable with the idea of losing money, and a low risk tolerance means you're less comfortable. 

Generally, there is a trade-off between risk and reward in investing. That means asset classes that historically have yielded the biggest returns, have the most potential for volatility.

For example, the equities markets have outperformed lower risk bonds long-term, but typically fall further during bad market days. 

If you decide you want to pursue higher risk investments, ask yourself, "Would I be happy seeing a significant drop in the value of my investment during volatile periods?”

Maybe look at risk through the lens of your day to day life. Do you often take risks? Would your close friends and family describe you as a risk taker? 

It’s also important to consider:

1. Investment time horizon – How much time do you have to invest? What stage of life are you in? If you have longer, you might be able to cope with some volatility, as long-term there’s a much greater chance your investment will yield greater returns than losses. 

2. Financial situation – How much would a fall in your investment affect your standard of living? (this is known as your financial capacity for loss). It’s recommended that you save 3-6 months of essential living expenses in cash as an emergency fund, and clear any outstanding high-interest debt before you consider investing. 

3. Liquidity needs – How much cash do you need access to in order to meet immediate financial needs. It might be a good option to keep some of your investments in something that’s easier to liquidate (sell) if you may need access to the cash in the near future. 

How to calculate Return on Investment (ROI)

ROI is a simple way to see how much money you’ve made (or lost) on an investment, relative to what you put in. To work it out, subtract the cost of your investment from the final value, then divide by the cost. Multiply that number by 100 to get a percentage.

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ROI = (Final Value - Initial Investment) / Initial Investment × 100

It’s a handy tool for comparing different investments, but keep in mind it doesn’t factor in things like time or fees.

Investing Strategies

There are a number of strategies you can use when investing, that suit a variety of risk tolerances and investment horizons. Not all of these strategies cater to a long-term strategy, so keep that in mind when choosing what’s right for you.

You also don’t have to stick to one strategy. Depending on your risk tolerance, you could combine conservative and speculative strategies, as a weighting of your portfolio – similar to the way you diversify using asset classes. 

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Growth Investing Strategy

Growth investing focuses on putting your money into companies that are expected to grow faster than average – think up-and-coming tech companies or innovative startups. These companies often reinvest profits to fuel growth, so you might not see big dividends, but the share price could rise significantly over time.

This strategy tends to suit investors with a higher risk tolerance and a long-term outlook.

It can be rewarding, but also more volatile, especially if markets dip or the company doesn’t live up to expectations.

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Value Investing Strategy

Value investing is like bargain hunting. You're looking for companies that are deemed ‘undervalued’ by the market – quality businesses going for less than what they’re really worth.

The idea is that over time, the market will catch on, and the stock price will rise. It’s a more patient, long-term strategy and usually involves digging into the specifics of a company (like earnings, assets, and debt).

This approach has been championed by legendary investors like Warren Buffett.

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Index Investing Strategy

Index investing is a low-maintenance, low-cost way to invest by investing in a whole market index (like the FTSE 100 or S&P 500), rather than picking individual stocks.

You’re spreading your risk across hundreds of companies, which helps balance out the ups and downs of any single stock price.

It’s a popular strategy for beginners and long-term investors who want steady exposure to the market without trying to ‘beat’ it. 

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Pound-cost Averaging Strategy

Pound-cost averaging means investing a set amount of money regularly, regardless of whether the market is up or down.

Over time, this helps smooth out the price you pay for investments and can reduce the impact of volatility.

You end up buying more units when prices are low, and fewer when prices are high, as the same amount is invested each time.

It’s a great way to build a habit of investing and avoid trying to time the market (which even the pros struggle to get right).

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Momentum Investing Strategy

Momentum investing is about chasing market trends. You buy investments that have been going up in value, with the belief that they’ll keep climbing (for a period of time).

This strategy relies on trends and market psychology, rather than company fundamentals. It can be potentially profitable in the short term, but it also comes with higher risk – prices can fall just as quickly. It’s not regarded as a long-term strategy, and it’s important to have an exit plan.

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Understanding Stock Market Basics

The stock market is, simply put, a place where buyers and sellers trade shares in public companies. When you buy a share, you’re buying a small piece of that company.

Stock prices move up and down based on how investors feel about a company’s future, as well as broader economic news.

Our next guide dives deeper into the basics of the stock market. 

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When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than your original investment. Chip does not offer financial advice and this should not be considered as a personal recommendation. Diversifying means spreading your investments across different sectors, countries and asset classes.