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Investing always comes with risk, but the level of risk varies and can be matched to different risk tolerances. Understanding risk through a few basic principles can help you determine your comfort level and make informed investment decisions.

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1. 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.

It’s important to align your investments with your comfort level, to avoid having a negative impact on your long-term goals. 

For example, if you invest in riskier assets and you aren’t comfortable watching your investing potentially go down dramatically, you might make impulsive decisions in difficult market periods. This could throw your investment goals off course.

Using a risk questionnaire or consulting a financial advisor can be a useful way to determine this, so you and your goals can stay on track. 

2. Investment time horizon

Your risk tolerance can also be influenced by how much time you have to keep your money invested. This might depend on how immediate your financial goals are, or what stage of life you’re investing in. 

For example, if you have short-term goals you want to achieve in the next three years, it’s probably worth exploring lower-risk investments. Similarly, if you’re looking to retire in the next few years, it might be worth taking a more conservative approach.

If you have longer to invest, for example, more than ten years, you might be able to cope with more risk as your money has more opportunities to weather the storms of market movement.

Just sticking with low risk assets long-term might have a detrimental impact on the value of your portfolio, due to the effects of inflation on the purchasing power of your money. 

3. Financial situation

Your risk tolerance is often influenced by your 'financial capacity for loss,' which is determined by your financial situation. Capacity for loss tells us the extent to which a fall in investible assets affects your future standard of living. 

It is recommended to have an emergency fund that covers 3-6 months' worth of essential living costs.

Prioritise clearing any outstanding high-interest debts before considering investing. Eliminating bad debt is an investment in itself, providing a clean slate for you to achieve your long-term goals. 

4. Liquidity needs

Your liquidity needs simply means how much cash or easily convertible assets you need access to, in order to meet your financial needs.

When investing, it’s best to avoid the need to ‘liquidate’ or sell your investments quickly (potentially at a loss), to cover an emergency expense. This money is best kept in an accessible cash savings account. 

However, if you do find yourself in the situation where you need to sell an investment to access the cash, it might be worth considering having a portion of your investments in a more easily accessible asset such as an ETF or index tracker.

Actively managed funds can only be bought and sold at one point in the trading day, and sell transactions can take longer to process.

5. Review and rebalance

It is crucial to regularly review your portfolio every few months and adjust it as needed to align with your personal and financial circumstances, as well as your risk level. Changes in asset values can impact the weightings of your investments, and your overall risk exposure. 

Learn about the principle of diversification in our key principles guide and how it can help you spread your risk between different assets.

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.

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