At university in her late teens, Meredith* decided to try investing in shares. She spent $2,000 on shares in two companies she liked the look of.

Unfortunately, the dotcom bubble collapsed and the value of her shares went to almost zero. More than 20 years later, Meredith still won’t invest in shares; she believes it’s just too risky. She now has over $300,000 in savings – all of it in the bank.

If you understand a bit about investing, you can see where Meredith went wrong initially, and where she’s going wrong now. Despite being a very intelligent person with a master’s degree and an excellent career, Meredith has flipped between taking too much risk and too little. Naturally risk-averse, she’s now doing almost nothing with her money, certain that if she makes any move something bad is just around the corner.

“People at work tell me about all the money they’re making in their investments, but they’re all doing different things, so it’s very confusing,” she says. “I keep thinking that maybe I should buy a house. But what if I do that and then I lose my job? The outlook isn’t that good … It could easily happen.”

Risk is unavoidable

Keeping her money in the bank makes Meredith feel safe, because it seems like a zero risk strategy. But she’s simply taking a different, less obvious risk. As her savings are eroded by inflation and she misses out on opportunities to put her savings to work, she’s risking a retirement with too little income to maintain her lifestyle.

Whatever you do with your money, you’re taking risks. At one end of the risk spectrum there are high-risk investments that can provide huge returns but leave you at risk of losing everything you put in – such as putting all your money into a single start-up. At the other end of the spectrum, there are strategies like putting all your money in a savings account, leaving you at risk of saving too little to achieve your financial goals. Everyone needs to find the right balance between those two extremes.

You need to know how much risk you’re comfortable with, what type of risks you’re willing to take, and what kind of risk fits with your financial objectives.

“You don’t want to take risks that make you feel like you’re living on the edge of a cliff all the time,” says Michael Cave, director of Cave Financial. “But the market also rewards you for taking some risk. So it needs to be calculated risk, ideally taken once you’ve built some financial resilience, so when market shocks do come, you’ve allowed for that.”

Risk-taker or risk-avoider?

Cave has met people all along the risk-taking spectrum: “For some people, a big mortgage keeps them awake at night, while others spend more time worrying about how to create the most wealth. There are also conspiracy theorists who think the banks are going to collapse, so they don’t take loans and instead buy gold.

“With my clients, I spend time both reassuring people who are taking reasonable risks, and talking to people who want to take risks that I think are too high for their situation.”

He believes our personal risk appetites are shaped by genetics and our experiences, especially the money lessons we learn from our parents. Our risk appetite can change over time; you might get more conservative as you approach retirement, or more comfortable with risk as your financial literacy and wealth grows.

Donna Nicolof, CEO of Pāua Wealth Management, bought her first apartment at the age of 17 and remembers how scary it felt: “I had a mortgage of $167,000 and it felt massive at the time – it was more money than I could ever imagine earning. I thought, ‘How am I going to pay this?’”

But time is an investor’s best friend, and that first purchase helped Nicolof get started on understanding and growing her appetite for risk. By knowing how much risk you can tolerate, you can make decisions about how to deploy the money you’ve got to help you achieve your investment goals and objectives, she says.

“Of all the conversations we have, risk is the single most important. It solves a lot of problems in the future, because markets are not linear. The worst thing you can do is panic when markets are down and sell, which only potentially realises your unrealised losses. We don’t want people making rash decisions because we haven’t had sufficient time to explore what their real appetite for risk is.”

The power of knowledge

Our perception of risk is not only shaped by our personal feelings, but also by what’s going on around us. The news tends to report on negative forecasts, playing to our fears. It’s important to try to filter out the noise from the media, says Cave, and stick to your own plans and goals. Instead of reading the headlines, financial advisers rely on data to illustrate risks in a less emotive and more measurable way.

For instance, financial advisers use models showing expected returns from various investment strategies, including best-case and worst-case scenarios, so you can make comparisons.

“Don’t look at the data every day,” Cave says. “Look at the long-term trend and the mathematical risk – it’s not a guarantee, but it’s an indication.”

For Nicolof, it’s also important to use metrics that make it real for people to feel familiar. It’s not enough to ask clients, “How would you feel if you saw the market had dropped 20 per cent in a day?” Instead, she puts it in dollar terms: “How would you feel if your $100,000 had dropped to $80,000 overnight?” If that would make you feel sick, it might not be the right strategy investment for you.

Diversification the key

Meredith’s mistake in her early investment loss was putting all her money into two individual companies. That lack of diversification hit her hard; if she had that money in an index fund or ETF, her result would probably have been quite different and she might feel more confident now.

Diversification is a powerful way to mitigate risk, because it spreads risk. For most investors, this means having a range of investment types from relatively low risk and low return, through to higher risk and higher return. Those higher-risk niche investments typically make up just 5 per cent of an individual’s portfolio, or less. In some cases they might only put in money that they’re prepared to lose.

Nicolof puts around 1 per cent of her portfolio into riskier investments like direct investments or start-ups venture capital. Even knowing she may never get the money back, she considers it partly an investment in her education because she learns about a new asset class, industry or product and supports New Zealand innovation.

Homework time

Learning about an investment is the best way to understand the specific risks involved – you have more context about the numbers, you get to know what could make the returns rise or fall, and you can see the long-term prospects for the investment.

“Do not invest in anything you don’t understand,” Nicolof advises. “If you’re not sure, seek professional advice, speak to someone who does know. If they’re worth their salt, they should be able to explain it.

“My son is 15 and recently he started a small share portfolio. I said, ‘I’m happy for you to invest your savings, but each time you invest you need to make a case to me around what you like about the investment and why.’ Unless you do your research, you’re just gambling.”

Questions on risk

When you’re considering your own approach to risk, there are three basic questions to get you started:

1. How much do you have to invest?

The first step in establishing how much risk you want to take is figuring out how much you want to invest. That will give you a sense of your financial capacity for risk-taking.

“Take the time to understand your balance sheet,” says Nicolof. “Understand what your operating budget is, so you know how much money you need to live on and how much you have to invest. This pre-work forms a good basis for thinking about the risk conversation.”

2. When do you need the money?

If you have a short timeline, you need to make sure your money is available when you need it. Instead of worrying about high returns, the priority will be security of funds. For example, someone who wants to go on an OE in six months might keep their savings in the bank, rather than in the share market. The funds are there for their trip when they’re needed, even if they didn’t grow.

With a long time frame, returns can become more of a priority, since you have time to ride out market volatility. With three decades until retirement, you’ll have a different approach to risk than someone who has only three years before they retire.

“Time is an important part of risk,” says Cave. “If you have a deadline for your money, you need low-risk strategies. With a distant timeline, you can take a bit of risk and reap the rewards.”

3. Do you understand the risks you’re taking?

Before you put your hard-earned money into any investment, you should make sure you know what you’re getting yourself into.

Ideally, talk to a financial adviser to get a better idea of the risks – or, if you have the time and the interest, do your own research. Everything you do with your money has its risks, and the better you understand them, the more well-informed your decision-making can be.

“You’ll never make perfect decisions,” Cave adds, “but with good advice and information, you can set your risk level appropriately.”

Don’t fall in love with one company

For people who want a higher-risk investment with potentially high returns, venture capital has always been an exciting asset class. Start-up companies have a high failure rate; around 90 per cent or even higher. But those who do succeed can make up for the failures, while a rare few will wildly outperform other types of investments; billion-dollar start-ups are called unicorns because they’re extremely rare.

"Venture capital investors know the risks, and they enjoy being involved with exciting innovative Kiwi start-ups," says Jack McQuire, partner at Icehouse Ventures.

“The return is more than just financial, because investors genuinely see how their money is creating a significant positive impact on the world. We have start-ups involved in environmental clean-up, green energy, creating high-tech jobs and generating export revenue. It’s exciting for investors to be part of something new and they’re motivated beyond just returns.”

One of the risks investors face is becoming too invested in the positive potential: “People do diversify, across 10 or 20 investments. Then they get a favourite and put in 20 times more money – so if that company falls over, most of their money is gone. That’s a mistake we see too many times, so don’t fall in love with one company.”

The most successful investors diversify across industries and take a long-term perspective on investing in new companies: “Investors should think about spreading their capital across an entire economic cycle, and building it up over 10 years.”

And for the founders of the start-ups themselves, the risk is even higher. They have little opportunity to diversify as they build their companies, because without committing 100 per cent to their business, it won’t become a success.

“Honestly, our advice to founders is: ‘Do you really want to do this?’ It’s bloody hard graft, and it’s thankless. They’re putting their careers on the line and taking a huge risk. The founders we’ve seen go the distance are all-in on their mission and have a mindset to de-risk every possible aspect of their business over time.

“They also know there’s a fine line between trying to know everything and taking action at the right time. You can always do more research, but at some point you need to make a decision – because every second you’re losing ground to competitors or technology.”

*Name changed for privacy.