What can you afford to invest?

Having learned what investing actually is, what are the two types of investment you really need to know about and why funds are an easy option, the next step on our investment journey is setting your investment goals and working out how much you can afford to invest. This means being clear about what you want to achieve and how much money you need to make that happen.

You also need to think about risk. The reality is that the higher the return wanted, the more risk you’ll need to take with your investment decisions.

Understanding attitude to risk

No investment is ever 100% guaranteed as all markets constantly rise and fall. Returns can also be affected by a variety of issues, including economic and political decisions.

Therefore, you need to know how much risk you can afford to take – and how comfortable you are with the prospect of losing money.

A popular way to measure attitude to risk is the amount of volatility – up and down moves in markets – you can endure. Cautious individuals, for example, might consider a 10% fall horrendous. The more gung-ho, meanwhile, may accept drops of more than 30%.

Then there is capacity for loss. This is your ability to absorb such falls in the value of your investments, even if it’s a short-term dip.

The best way of doing so is to consider the impact on you – and your dependents – should you end up losing every penny invested. Would you be financially devastated or have you other assets to fall back on? The golden rule is only invest what you can realistically afford to lose.

How much this figure is will depend on factors such as your age, occupation and income, marital status, and whether you have any dependents. It will also depend on your investment time horizon. If you are young and intend investing for several decades, then you can maybe accept more risk.

However, if you need to meet financial obligations in the near future – or are heading towards retirement – then you may not have time for your investments to recover from valuation dips.

How much can you afford to invest?

This will depend on your own situation. No two people are the same. We all have different financial objectives and commitments that affect how much money we have available.

The first question is: Do you have any outstanding debts? If so, then clear those before you start committing money to the stock market. The returns generated by investments may not be higher than the level of interest you’re paying each month to service repayments on loans and credit cards.

Then consider how much money you have in various savings accounts. Everyone should have a so-called ‘emergency pot’ of easily accessible money for use in an emergency. For example, what would you do if you suddenly needed to find £4,000 to replace a boiler or your car needs extensive work to get it through the MOT? If you haven’t got an emergency pot already, start saving now and leave investing until later.

The final stage is to take a close look at your income and outgoings. How much money have you got coming in each month? Where is it going? Do you have much left over?

It’s best to approach your personal finances in the same way as a business looks at its balance sheet each month – then see if there are any expenses you can reduce.

Your employment situation is also relevant at this point. No-one knows for sure if their income is secure but it’s something you need to bear in mind. For example, are you running your own business or working for someone else? If it’s the latter, are you climbing the ladder and anticipate your salary rising sharply over the next few years?

Once you know how much money you can make available – on top of the emergency pot and other commitments – you’ll have a better idea of what you can invest. And remember, it doesn’t need to be a big lump sum. You can invest a smaller amount each month instead.

Then you need to think about your future plans. Not only will these have an impact on the amount you can put away – but also affect the length of time you can have it invested.
Are you wanting to generate a set amount of money over a particular period? Are you looking to clear your mortgage or put your children through university?

Striking the right balance between risk and reward

Of course, it all comes down to striking a balance between taking enough risk to achieve your investment goals, but still being able to sleep soundly at night.

The risk investors are willing – and able – to take can be defined in any number of ways. However, here is a broad suggestion to how they can be categorised. Lower risk investors feel happier embracing so-called safer investments because they are more concerned about losing their money than making a huge return. This means they are more drawn to assets such as fixed income – particularly government bonds and investment grade corporate bonds that are less risky than equities.

Then you have medium risk investors. These people accept they will need to take some risk with their money in order to generate the returns needed. However, they don’t feel comfortable putting all their money into high octane funds that are focused on fast growing companies or volatile regions of the world. Instead, they may decide to have most of their investments in reliable companies, and then add a few more exciting funds into the mix. This is known as a core and satellite approach.

The final category are the higher risk investors. These individuals are focused on generating the best possible returns from their investments and accept they’ll be taking more risk. Often, these people will have plenty of other assets and savings, which means they will be less affected by short-term, or even longer-term, losses. Their approach may see them drawn towards emerging markets, for example, which are likely to be volatile, but which also offer the prospect of bumper potential returns.

Of course, just because you fall into the cautious category now, doesn’t mean it will be the right call for the rest of your life. Your situation will change, and this may influence your investment choices.

This is why you should reassess your life goals and risk appetite every year to ensure that your investments are on-track to deliver the returns you expect.

This is step 4 of 5 in our “5 steps to investing” — continue to step 5: How to make an investment. Need to go back to step 3 — Why funds are an easy option.

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