Whether you are investing money, setting up a business or gambling on horses, your first consideration, before parting with any money, should be how much risk you can afford to take. Risk is not necessarily the probability of loss – it is the probability that an outcome will be different than you expect. For example, an investment might make a positive return, but a lower (or higher) return than you expected.
There are two aspects to risk that determine how much risk you can take. The first is your tolerance for risk. Some people are naturally risk takers or thrive on the exhilaration of taking a gamble, while others have trouble sleeping at night when outcomes are uncertain. The second aspect to risk is your capacity to take risk. In essence, this is the amount by which the actual outcome can differ from your expected outcome without having a lasting impact on your financial situation. If we put these two aspects together, we get four possible combinations:
Low risk tolerance and low risk capacity. If you are in this category you clearly need to tread a very safe path.
Low risk tolerance and high risk capacity. This combination means you are probably being more conservative than you need to be and may be missing out on opportunities.
High risk tolerance and low risk capacity. This is a danger zone! You are taking risks with money you cannot afford to lose.
High risk tolerance and high risk capacity. Fortunes can be made in this category. You have both the resources and the courage to take risks in exchange for the possibility of a high return.
Understanding your risk tolerance and risk capacity can help guide you to making financial decisions that optimise the balance between risk and return for your particular circumstances.