As an experienced investor, I’m often asked about risk. It’s a fascinating area, and one that is in many ways intensely personal. Some people are naturally attracted to risk, while others are far more cautious. Both groups can, in my experience, be just as effective as investors as the other.

But first, here’s a quick explanation of what risk actually is, in investment terms.

At it’s most basic level, risk is ‘uncertainty’ – that quality of the unknown that every potential investment contains. And that word ‘quality’ is actually an important one for me, because it underlines that risk is, in many ways, a neutral concept. It is neither intrinsically good nor bad: its positive or negative impact on your investment is relative, and depends on a complex web of other factors.

Understand its relationship with reward

In the world of investing, two words are often heard together – risk and reward. And it is fair to say that most investment decisions you make will revolve around balancing these two variables. The risk in this sense is what you could potentially lose, while the rewards are the returns you hope to enjoy at some point in the future, when you realise your assets.

Be aware however, that the relationship between risk and reward isn’t necessarily a straightforward one. Most people imagine that when you want the rewards to go up, you take more risks. And that if you’re not prepared to take more risks, then you have to accept that the rewards will be lower too.

But some research suggests that taking on riskier investments, from real estate to stocks and shares, doesn’t always mean higher returns. Because higher risk investments encourage people to gamble on them, hoping for higher returns, there’s a good chance that those investments may actually be poor quality.

Often, it makes more sense to go with higher quality, less risky investments, that are proven to give a steady return over time. In real estate in particular this is a strategy that certainly pays off.

Understand what your risk appetite is

One of the most important concepts to understand when you are thinking about risk is the idea of ‘risk appetite’. I like the Institute of Risk Management’s definition of this idea: that risk appetite is ‘the amount and type of risk that an organisation (or individual) is willing to take in order to meet their strategic objectives.’

But how do you go about identifying what your own risk appetite is? Well, in my experience it is a complex, but incredibly important process to go through. There are three key elements that you will need to take into consideration. Of course, the relative weight of these factors will differ from individual to individual, but broadly speaking they are as follows.

The first are your own feelings about taking risks. Some people are simply more risk averse than others, and this is an important and unavoidable factor in any investment decision.

Secondly, you need to take into account the amount of risk you will need to take in order to reach the investment goals you’ve set yourself. It may be that some financial goals require you to take more risks – for example if you need to make money over a short time period.

Thirdly – and most importantly, you need to understand how much you are able to lose without dramatically altering your existing way of life.

Once you have a sense of all of these factors, you will then be well-placed to assess how big your appetite for risk actually is.

Know the different types of risk

Risk is a complex beast: it can take many different forms. One of the most important kinds of risk is market risk – simply how likely your investment is to devalue if the market falls.

For investors, market risk can be further divided into equity risk, linked to price volatility, interest rate risk and currency devaluation risks.

Of course, this kind of market risk also feeds directly into another area: liquidity risk, which is your ability to get any returns from your investment. If the market falls, the value of your asset might drop too, and you will be exposed because you can’t sell without suffering a loss.

Managing risk

Finally it’s important to understand that there a number of different strategies to follow if you’re wanting to mitigate risk across your portfolio of assets.

One of the most obvious, of course, is diversification. By not focusing all of your investments in one area – for example commercial real estate, or gas industry stocks – you reduce the risk that your entire portfolio will suffer in the event of a price drop.

But there is another level to this too – asset allocation. Instead of simply spreading your investments across electric vehicle stocks as well as gas industry ones, you might want to look at a whole new asset area too.

By investing in something like real estate, or government bonds, as well as your stocks and shares, you are spreading the risk even further.

Risk is an incredibly complex area, but if you want to succeed as an investor then you have to understand, at the very least, what it means for you personally. Understand it as well as you can, and use it as a factor against which to balance every single investment decision you make.