The return you get on any investment is compensation for the risk you are taking. Or to put it another way, if a high risk company wants to encourage you to invest in them, they recognise they have to offer you a higher return to do so.

In general, in developed markets such as the UK, the ‘risk free’ rate of return is seen as the yield available on government bonds. Developed market governments are seen as highly unlikely to default on their debt, so investors are likely to get their money back. In the UK, that rate is somewhere between 2% and 2.5%. If investors want a higher return, they have to be prepared to take some risk of a capital loss on their investment.

This risk of capital loss – and therefore, confusingly, the chance of making a higher return – will vary significantly from asset class to asset class. Investors can pick up clues as to how a certain investment may behave in the future by looking at the way it has behaved in the past. This is an imperfect measure, but no-one has a crystal ball. For example, in the worst period for stock markets, an investor in the UK market will have lost around 30% from peak to trough. They have subsequently made that money back and then a bit more, but an investor has to have the time and patience to hold on through those difficult times.

The extent to which you can deal with these short-term losses – either financially or emotionally – will be an important determinant of the types of asset in which you invest. If you are happy to ride out the markets’ ups and downs, you have a higher risk tolerance and can look to invest in stock markets. If you have significant concerns about losing any capital at all, then you have a lower risk tolerance and may need to confine your investment horizons to lower risk government bonds. There are other variables, such as your time horizon, and the nature of your financial goals, but your emotional and financial tolerance for short-term loss of capital is key to establishing your tolerance for risk.