Financial independence - what it is, and how you can get it sooner

The answer is: it can be. But it really depends on what you mean by ‘risky’. There are different types of risk, and there are ways to handle them.

Some investors describe themselves as ‘risk averse’; others are happy to buy ‘high risk’ investments. You're always told to invest according to your ‘risk appetite/tolerance/profile’. But what does all this talk of risk mean in practice?

Many people define investment risk simply as ‘price volatility’ - so they say an investment’s risky if its price moves up and down a lot. This is a reasonable starting point. If the price falls sharply just before you need to take some money out - ouch. Especially if you’re about to put down a house deposit, or stop earning money. But if you’ve got many years of investing ahead of you, a falling price is much less of a risk. The stock market as a whole goes up over time, so it shouldn’t necessarily matter that it doesn’t go up in a straight line (if you think about it, you should welcome falling prices in the early years with open arms).

Let’s use a wider definition for investment risk - let’s simply call it ‘losing money’. There are three main ways* you can lose money when you invest.

• Your investment becomes worthless one day, because, for example, the company you invested in goes under. Or your investment turns out to have been worthless from day one, because you were scammed.
• The price of your investment falls, and you actually sell it at a price that’s lower than the price you bought it at. This is the price volatility issue.
• The price of your investment goes up over time, but never enough to keep up with inflation. So when you sell, you get back more money than you put in, but its spending power has actually gone down. This way of losing money is often overlooked.

So how do you reduce the risk in each of these situations? It’s actually quite straightforward.

• Don’t put all your eggs in one basket - spread the risk. This means not putting all your money into one company, or even one sector or one country. And try not to get scammed!
• Never be forced to sell when prices fall, potentially turning a paper loss into a real one. This means having enough cash, or something similar to it, easily available when you need it.
• Don’t keep all your money in cash or bonds if you need it to last a long time. This means owning shares, so you beat inflation.

So how you invest determines the risk as much as what you invest in. That’s why you need to question oversimplified statements like ‘the stock market is a casino’, or ‘bonds are safer than shares’. Yes, day trading is akin to gambling, and bonds tend to be less volatile than shares. But that’s not the whole story.

(*) There are other ways to lose money too. First, even if the price of your investment goes up over time, charges and taxes will eat into your return. To deal with this, you should generally keep the cost of investing as low as possible, and use tax wrappers like a pension or an ISA. Second, if you pick a handful of stocks, or let a fund manager do it for you, you might end up doing worse than the market as a whole. This is the, often-heated, debate around 'active' investing versus 'passive' investing.