Investment risk is a concept inseparable from every financial decision. While dreams of significant gains can be tempting, the fear of loss often holds people back from taking any investment action at all. But what are we really afraid of: loss, or investment risk?
Losses can stem from many factors: unpredictable market changes, poor investment decisions or sudden economic events. The world of finance is full of surprises, and every move in the market carries an element of uncertainty. That’s why you need to understand what investment risk is and gauge your own risk tolerance.
It comes down to assessing the investment’s risk, getting to know your own reactions to potential losses and determining how much risk you’re able to accept in order to reach your financial goals.
It’s not only a matter of numbers and percentages, but also of emotions and psychology. How will you react to market drops? Can you keep calm in the face of a loss on the stock market? Or will you panic and sell in a hurry? This article will help you determine your risk tolerance and design your own safe investment strategies.
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What is investment risk?
Risk is one of those words that immediately stir up emotions. But what is investment risk, exactly? In the simplest terms, risk is the possibility that something won’t go according to plan. That an investment won’t bring the expected returns, or that we might even lose part of our money.
When I worked at a bank, clients often asked me: „Mr. Tomasz, can you lose money on investment funds?”. I’d answer: yes, you can. But you can also lose on treasury bonds and on a bank deposit. There’s no escaping risk. And if someone does nothing, then there’s no risk of loss – there’s the certainty of loss. By doing nothing, you lose 3% of the value of your money every year, because the value of money falls.
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People are afraid above all of loss, which is why they choose safe investments. Investing on the stock market has a particularly bad reputation, because the risk of investing in shares is higher if you lack experience. A loss on the stock market can result from many factors, such as unpredictable market changes, poor investment decisions or sudden economic events.
Risk is something we’re aware of. Thanks to that, we can make informed decisions about how to respond to specific events. But there’s something worse: uncertainty. Those are all the aspects, elements and scenarios we can’t predict and aren’t even aware of.
The financial market is a complex place, full of variables and unknowns. Sometimes we simply don’t know what lies ahead. Uncertainty can be paralyzing, but you can deal with it through financial education.
Learn the basics of investing, and you’ll turn uncertainty into risk you can manage – and that will be a big step toward protecting yourself from a loss on the stock market, in investment funds, real estate or any other form of investment. With knowledge, you can gauge your investment risk tolerance.
When does a loss happen?
A loss on the stock market is the moment every investor would like to avoid. Where does the risk of investing in shares or any other financial instruments come from? There are two main scenarios that lead to a loss: the bankruptcy of the entity we invest in, and a crisis or bear market.
Bankruptcy is the moment a company announces it can’t pay its obligations and ceases operations. Investors lose the money they invested, because the value of such a company’s shares often falls to zero, and frequently even bondholders struggle to recover their funds (although they’re in the queue much, much earlier than shareholders).
Bankruptcy can result from many factors, such as poor management, bad business decisions, overly risky investments (e.g. in complex derivatives), excessive debt or unfavorable market conditions. And sometimes political decisions too. That’s why it’s so important to thoroughly analyze a company’s financial health and its market environment before investing.
The second scenario is a crisis or bear market. An economic crisis is a period in which the whole economy slows down, which leads to a drop in the value of most assets. At such times investors often panic and sell their assets at low prices, which only deepens the declines.
Losses in such a scenario stem mainly from emotions and human reactions to short-term market fluctuations, which are a natural part of its cycle. Gauging your investment risk tolerance can protect you from investing in instruments whose volatility goes well beyond your ability to control your emotions. Remember that the biggest mistake in investing is following your emotions.
How to invest without losing?
To avoid losing, you need to pick instruments that won’t go bankrupt and, during a bear market or crisis, keep a cool head. Simple, right? Maybe on paper, but when you watch your life savings shrink by 25%, a lot less so.
If you build a portfolio of 30 well-selected companies, you won’t have to fear losses. It may happen that one of them weathers a crisis worse than the market, but spreading your money across many companies means the drop in value of that one won’t matter much. The risk of investing in shares this way will be comparable to investing in investment funds.
If you’re investing with a horizon of several years, be prepared to go through at least one crisis, because the economy moves smoothly through various business cycles. That’s why it’s worth considering hedging strategies.
Besides diversification, the basics also include a stop loss or cost averaging. A stop loss means automatically selling shares when their price drops to a set level or below the trend line. Cost averaging is buying regularly, regardless of the price on a given day.
The question „can you lose money on investment funds” is, to me, a similar question to „can you crash a car?”. Well, yes, you can – but why would you? If you drive well, you probably won’t crash. There can be an accident caused by someone else, but that’s no reason to walk everywhere your whole life, right?
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Remember that the financial market is a dynamic and unpredictable place. Losses are an inherent part of investing, but with the right financial knowledge and tools you can minimize them and build your own safe investments.
The most important thing is not to panic and to stick to a well-thought-out investment strategy. And the best long-term strategy is „cut your losses and let your profits grow”. That way you’ll bring the risk of investing in shares down to the lowest possible level.
Gauging your investment risk tolerance step by step
In the world of finance, every decision carries a certain level of investment risk. The risk of investing in shares is higher, the risk of investing in bonds lower – but it still exists. Deposits aren’t free of risk either. Before you set off on this fascinating but challenging journey, it’s important to know your limits and understand what risk tolerance you’re able to accept.
This guide will help you, step by step, assess the investment risk you’re able to tolerate, so you can make informed and considered investment decisions.
Why is understanding your investment risk tolerance so important? Imagine you’re setting off on a mountain climb. Before you start climbing toward the summit, you need to know your physical abilities and limits in order to avoid dangerous situations. How many people have died in the high mountains simply because, at the cutoff hour, instead of starting to descend, they kept clambering toward the top?
It’s the same with investing. By knowing your risk tolerance, you avoid unnecessary stress and panicky decisions that can lead to a loss on the stock market. That’s what safe investment strategies are prepared for – to stick to them when emotions start to take hold of you. Trust yourself and your analysis: when the price reaches an auto-call or a stop loss, sell. You set those levels of investment-hedging strategies precisely so you could use them when the time comes.
Risk tolerance is not just numbers and percentages. It’s also your emotions, your reactions to market changes and your readiness to survive tougher periods and stick to the safe investment strategies you’ve set.
Define your investment horizon and financial goals
The first step toward understanding your investment risk tolerance is to think carefully about how long you plan to invest and what your financial goals are. It’s a bit like planning a trip – you need to know where you’re heading and how long you intend to stay there. Whether to choose safe investments or higher-return ones depends largely on how much time you have.
If your financial goals are more short-term – for example, you’re saving for next year’s holiday or planning to buy a new car in the next few years – your approach to risk should be cautious. When you don’t have much time to recover potential losses, you have to be more careful in choosing investments.
The market rises over the long term, but if you look closer, its growth has the shape of a sine wave – because of business cycles. In the short term you can’t invest in instruments with a wide range of volatility, because you might buy them at the top and end up having to sell at the very bottom. That’s exactly how most people take a loss on the stock market or when investing in investment funds.
Remember what risk is: risk is a measure of volatility, not the probability of incurring a loss.
If you’re planning long-term savings – for example, for your children’s education or a comfortable retirement – you can afford larger market swings. You can choose investment funds with a risk category of 6 or 7, or invest in shares, because such instruments grow much more over the long term than safe investments. Just take into account the other aspects that determine your investment risk tolerance as well.
Comparing the long-term returns of equity and debt funds
For comparison, over five-year periods equity investment funds, which carry higher risk, achieve an average annual return of 12–16%, while debt and money-market funds with limited risk return around 6%. In the chart below from the analizy.pl portal you can see a ranking of investment funds by the return achieved over the last 5 years. BNP Paribas MIŚS happened to achieve an average annual return of 26.54% in 2019–2024, but funds from Santander, Rockbridge or Goldman Sachs have an average annual return of 15–17%.
And here you can see safe investment funds, i.e. risk category SRRI 2. Their returns over the last five years range from 4.55% to 6.52% per year. And remember, this is the TOP – that is, the best of them.
Choose safe investments when you need your money back within a year or two. If your horizon is several years, you can comfortably choose more volatile investments, because over the long term they’ll do best.
How much do you know about investing?
Your knowledge of the financial market and of investment instruments is another key factor in the process of assessing your investment risk tolerance.
One of the most important rules of investing is „invest only in what you understand”. The more you know, the more confident you feel making decisions and the lower your risk in investing. Understanding how various financial instruments work lets you better assess both the potential gains and the risks involved.
Think of your investment education as a set of tools – the more tools you have in your box, the better prepared you are for different market situations.
If you’re just starting your adventure with investing, the sheer number of options can be overwhelming, and the risk of investing in shares may seem unacceptable. In that case it’s worth considering consulting a financial advisor.
Professional help can provide valuable guidance and help you avoid basic mistakes
If you’d like, I can help you understand what investment risk is and help you choose safe investments tailored to your current knowledge and risk tolerance.
My help will be strictly mentoring, coaching and educational in nature. Regulations prohibit providing investment advisory services without the appropriate authorizations. I’ll simply help you gauge your risk tolerance, but I won’t point to any specific financial instruments.
Beginnings in investing often involve choosing less risky instruments, such as money-market or debt investment funds, whose risk is significantly limited but whose returns exceed bonds and bank deposits. It’s an excellent way to understand the basic rules of the financial market without exposing yourself to too much risk. Over time, as your knowledge and experience grow, you can gradually expand your portfolio with more complex and potentially more profitable instruments.
Remember that investment education is an ongoing process. Financial markets are dynamic and constantly changing, so it’s important to keep expanding your knowledge. The more you know, the more informed and confident your investment decisions will be, and the more accurate your investment risk assessment.
What investing experience do you have? What investment results do you have?
Time horizon and goal are one thing, knowledge is another, but you can’t consider yourself an expert if you have no experience. You can listen to well-known traders, but if your best financial result is earning 120 PLN on a six-month deposit of 6,000, then forgive me, but you’re not ready to invest in CFDs on the WIG 20.
Your past experiences, both positive and negative, shape your approach to investing and your comfort level with taking risk. Think of your investment experiences as life lessons – every gain or loss provides valuable knowledge.
If you have successful investments behind you and can handle difficult market situations well, you’re probably more inclined to take risk. People with positive experience often have greater self-confidence and are ready to explore more aggressive investment strategies.
Just because you know what the basic technical-analysis patterns look like, such as the head and shoulders, doesn’t mean you’ll spot one on the actual chart of your investment. Knowing market mechanisms and being able to manage your emotions during market turbulence form a solid basis for growing your portfolio.
If, on the other hand, your investment experiences were negative, that can affect your risk aversion. Financial losses and disappointment can make you more cautious in future investment decisions. That doesn’t mean, however, that you have to avoid risk entirely.
Would what you lost on the stock market exceed the cost of postgraduate studies? Because that’s exactly the category you can treat losses in – as education. The important thing is to understand what went wrong and draw conclusions that will let you avoid similar mistakes in the future.
When assessing your investment experience, look at it as a whole. What did you manage to achieve? Which strategies were effective? What mistakes did you make and why? Analyzing your investments so far lets you better understand, firsthand, what investment risk is and which approach to risk suits you best.
Determine your psychological profile based on a test of whether you can execute a stop-loss
Finally, we come to the greatest threat to your investment. That threat is you. People are capable of making foolish and inexplicable decisions under the influence of emotions. That’s why understanding your approach to risk and the way you react to losses can be crucial for effective investing.
Ask yourself a simple question: are you able to take a 5% loss when a stop-loss is triggered? The ability to accept losses in order to avoid bigger financial trouble is crucial for an investor who opts for more profitable investments. If you can decide to execute a stop-loss without hesitation, you probably have a higher risk tolerance and better control over your emotions.
If the very thought of closing a position at a loss causes you a lot of stress, it may indicate that it’s better to avoid risk in investing and stick to lower returns. I understand to some extent – selling assets at a loss can be hard to accept, much like admitting a mistake. It’s important to understand your emotions and learn how to manage the stress that comes with investing.
The market rises over the long horizon, but when you look closer, you’ll see business cycles – alternating crises and economic upswings. And if you look closer still, you’ll see that in a single day a given company’s shares can lose as much as 10%. Moreover, there’s no investment without risk. Deposits? Many banks have collapsed. Bonds? States can be insolvent too. You won’t escape risk.
And remember that by not investing, you accept a certain loss of 3% a year due to the change in the value of money over time. So it’s better to invest, even if it’s in safe investments, but to carry out an honest investment risk assessment. If you might have trouble executing a stop-loss, it’s worth sticking to lower returns, but also smaller possible drops.
What impact will a loss have on your life?
And the last factor. You may have a long time horizon, you may have knowledge, experience and results, and close a position with a 20% loss without blinking when a stop loss is triggered. But for heaven’s sake, don’t invest all your life savings in futures with x20 leverage or in cryptocurrencies!
Before you decide on any investment, it’s worth thinking about how a possible loss would affect your life. This is a key aspect that’s often overlooked, yet it’s hugely important for your risk tolerance.
Imagine a scenario in which you lose part of the money you invested. Would such a loss significantly affect your financial situation and everyday life? It’s worth considering whether you have enough savings to cover potential losses.
Do you have an emergency fund that will let you calmly get through tougher times? Investment losses can be less painful if you have financial protection in case of unexpected events. Without such protection, even small losses can be noticeable and stressful. In that case, it’s better to avoid risky investments.
Risk tolerance will differ depending on the context. You’ll take a different approach to handling your retirement fund a few years before retirement, when the priority is protecting capital with safe investments, than to investing 5% of your monthly salary, which you can afford to lose without major consequences.
Ultimately, the key is to keep your balance. Investing is not only a chance for gains, but also the risk of losses. It’s important that you understand what impact those losses could have on your life and adjust your investment strategy accordingly.
There’s no investment without risk, but there are rules of investing that let you invest with greater peace of mind and confidence that, even in the face of losses, your financial situation will remain stable.
Summary
Gauging your risk tolerance is a key step in the investment process that provides a solid foundation for all the financial decisions you make. It’s like building a house – without proper foundations, any structure can wobble and eventually collapse. That’s why it’s so important to assess the investment’s risk and understand your tolerance thoroughly.
The first piece of this puzzle is defining your investment horizon. Think about how long you plan to hold your investments and what financial goals you want to achieve. Your plans for the future will affect how much you can afford market swings and which investment strategies will suit you.
The next step is analyzing your knowledge and investment experience. How much did you lose on the stock market or on funds? Why? Recall the emotions that gripped you back then. Your own experiences are a priceless course in investing – the best one you can give yourself.
The more you know about the financial market, the more confident you feel making decisions. Remember that investment education is an ongoing process – it’s always worth expanding your knowledge and following market changes. Your experiences, both positive and negative, shape your approach to risk.
Don’t forget, either, that you’re human. How do you react to stress and losses? Are you able to make hard decisions, such as executing a stop-loss? Understanding your approach to risk will help you manage your emotions better in difficult moments. Finally, think about how a possible loss would affect your life. Do you have adequate financial safeguards? What would the consequences be for your life situation?
Investing involves risk, but with the right knowledge and preparation you can manage it effectively. Remember that the key to success lies in a conscious approach and in regularly adjusting your strategy to changing circumstances. That way you can invest with greater peace of mind and confidence that your decisions are well thought out and based on solid foundations.
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