If you are going to start investing, the first important concept you need to understand is risk. As well as assessing the amount of risk that you feel comfortable with, you also need to know how much you can actually afford to take.
This will depend on a variety of factors, including your age, the amount you're investing and whether you have - or intend to have - any dependants.
In the first lesson of Moneywise's Investment School - which is here to make sure you can graduate as a confident investor - we show you how to determine what risk you should take.
Risk and reward
So let's start with some golden rules.
Arguably the most important is that the greater the return you want to achieve, the higher the risk you'll have to accept. This means having to accept the increased possibility of losing some - or all - of your original investment.
Another rule concerns the length of time you plan to invest. If this is a relatively short period - often referred to as less than five years - then you may want to steer clear of riskier assets because there probably won't be enough time for you to recover from any losses.
The simple fact is that no investment is totally risk-free. Therefore, before you commit a penny you need to decide how comfortable you are with the prospect of your money going down in value - even just a short-term dip on the way to longer-term gains.
This attitude to risk can be measured in different ways but one of the most common is the amount of volatility – ups and downs in the market – you can endure. For example, a cautious investor might be panicked by a 10% fall, while the more adventurous could shrug off a drop of, say, 40%.
You also need to take into account your capacity for loss. This means the ability to absorb falls in the value of your investment. If any loss of capital would have a detrimental effect on your standard of living, this should be taken into account when assessing the level of risk that you are able to take. Only invest what you can afford to lose.
Examine your own situation
You then need to consider your personal circumstances. No two people are the same – or want the same things from life – so the investment decisions you make all come down to your individual outlook, the stage in life you've reached, the level of income you enjoy, and your short and longer-term financial objectives.
If you are young and intend to invest for a number of decades then you can probably afford to take on more risk than someone already retired.
Not only will this probably be the only way to make your money grow by a decent amount, you will also have the comfort of knowing you have time to recover from major losses.
You also need to look at your wider financial situation. How much money do you have in savings accounts? Have you got a pension? Do you own any other assets? These are important questions in ascertaining how much of your spare money you can afford to invest.
Linked to this will be job security. For example, do you work for a young, riskier, start-up business or for a long-established firm making decent profits?
You also need to look at what you need the money for. Are you expecting to settle down and buy a house? Will you be having children and want to set aside money to pay for school fees? Are you close to retiring? Do you want to buy a holiday home abroad within five years?
Your future plans will not only have an impact on the amount you can invest – but also the length of time you can have it invested. In addition, these important factors will determine what asset classes are the most suitable.
Decide on your risk appetite
After considering these factors you should have a good idea of both your attitude to risk and your capacity for loss. It's now time to see which risk category - lower, medium or higher - best suits you.
Lower-risk investors prefer to put their money in safer investments because they are concerned about losing their money or simply haven't got a long enough timeframe to invest in riskier vehicles or areas. No investment is completely safe, but lowerrisk products include bonds and pooled investments that contain a diversified mix of asset classes.
Medium-risk investors, on the other hand, accept that they will have to embrace a certain level of risk in order to have a chance of generating decent returns but don't feel comfortable putting all their money into funds that focus purely on more volatile areas of the world.
The higher-risk category is for those who want to generate the highest possible returns on their investment - even if that means running a significant risk of losing the lot in unfriendly market conditions. They will often either have excess money or a need for it to rise in value by a certain amount.
Fund recommendations for all types of risk-taker
Cazenove Multi Manager Diversity
Fund managers: Marcus Brookes and Robin McDonald
“This is a defensively managed fund that invests equally in equities, cash and fixed interest and alternative investments such as property, structured products or commodities,” says Patrick Connolly, spokesperson for AWD Chase de Vere. “While fund performance is never going to ‘shoot the lights out’, it performs consistently and charges are competitive.”
Invesco Perpetual Distribution
Fund managers: Neil Woodford, Paul Read and Paul Causer
“This fund combines the expertise of Invesco’s very experienced fixed-interest team of Paul Read and Paul Causer with equity investor Neil Woodford,” says Mel Kenny, director of Radcliffe & Newlands. “It’s still susceptible to loss, due to the equity, but if we’re presuming low risk still means having some equity exposure it is interesting.”
Jupiter Merlin Balanced
Fund managers: Algy Smith-Maxwell, John Chatfeild-Roberts and Peter Lawery
“It has up to 85% equity exposure but is headed up by John Chatfeild-Roberts and is a multimanager fund that’s a great one-stop-shop for those who don’t have a great deal to invest,” says Kenny.
Edinburgh Investment Trust
Fund manager: Neil Woodford
“I like the Edinburgh Investment Trust, which has a good manager at the helm who is prepared to take a position and hold it,” says Dennis Hall, founder of Yellowtail Financial Planning.
JPMorgan Emerging Markets
Fund manager: Austin Forey
“Emerging markets are some of the fastest growing and most dynamic economies in the world today,” says Andy Gadd, head of research at Lighthouse Group. “This fund is suitable for investors with an investment horizon of five to 10 years who are willing to take on additional risk in exchange for higher potential returns.”
Templeton Emerging Markets Investment Trust
Fund manager: Templeton Asset Management
“I’ve been a fan of Templeton’s Emerging Market Investment Trust for quite some time,” says Hall. “It is one of the larger investment trusts and has relatively good liquidity as well as decent performance for its size.”
Monitor your risk preference
Of course, just because you fall into, say, a higher-risk category now, doesn't mean that will always be the case. A new baby could massively alter your risk profile, as could retiring.
That is why you should reassess your life goals and risk appetite every year. Ask yourself the same set of questions and gauge whether your circumstances have changed in a material way.
Remember that while you can't eliminate risk from your investments, you can manage it by having exposure to a broad range of assets. This is known as diversification. The hope is that any losses suffered by some financial products will be balanced out by gains made elsewhere.