You get rewarded with higher returns for taking on more risk. It is as bad to take too few risks as too many. See Risk Premiums later.

Risk categories

Here are things you should look out for

• Inflation risk - the risk that your money will not buy what you thought it would.

• Counterparty risk - the chance that the person or body (the 'counterparty') on the other side of your investment will fail to deliver on his promise to you.

• Default risk - the chance that you will fail to get back all or part of your capital.

• Capital risk - the chance that the asset in which you have invested will not achieve the value you expect.

• Liquidity risk - the chance that you will be unable to sell your investment when you want at the price you expect.

• Ownership risk - the chance that someone else has rights to what you thought was yours.

• Income availability risk - the risk that your surplus income available for investment will change through personal circumstances.

• Flexibility risk - the inability to adapt your investment to new circumstances.

Each dimension is to some extent measurable. You can have high or low inflation, high or low default risk, you can be locked into investments for a short or long time.

Each dimension has a time factor. The risk of something happening within a given period will increase with the length of that period. The risk of being unable to recover from accidents will decrease with the length of the period.

Each dimension has high or low importance for you - depending on your circumstances, your plans and your risk tolerance. Only you can decide whether an investment is more or less risky for you compared to other uses of your money.

A word on ‘volatility’

In technical investment circles the word 'risk' has come to have a precise meaning - namely 'volatility', or 'the tendency of things to swing about'.

The word ‘volatility’ does not appear in the list of risk categories above. That’s because it is best described as ‘capital risk’. Your need for capital will usually be dictated by events outside your control. If that happens to coincide with the undervaluation of a volatile asset you will get less than you expected. Put another way, the value of an asset only matters one two occasions: when you buy and when you sell.

So it’s only a small part of the picture. But it happens to need a lot of heavy mathematics which can then be packaged into financial products advertised as ‘reducing risk’.

Be wary of statements about risk in investment literature which can:

• be over-simple (what does 'reducing risk' actually mean?)

• claim more than they can deliver (......will reduce risk....)

• ignore the personal side

The weapon against risk…..

…… is diversification. This is the most important single concept in long-term money management, sometimes called ‘the only free lunch’. It means taking lots of small risks instead of a few big ones. The next page explains.