Understanding risk and return

What you’ll learn:

• How the relationship between risk and return works
• How to manage risk
• What types of risk you'll face when you invest.

The risk and return conundrum is central to most investment decisions. Taking on more risk can mean potentially higher returns but there’s also a greater chance of losing money. On the other hand, less risky investments may provide you with more secure returns, but these are likely to be lower.

Fundamentally, risk relates to the potential financial losses associated with a specific investment or investment strategy and there are a number of obstacles you are likely to come up against as an investor.

Market risk

Market risk, also called ‘systematic risk’, is determined by factors that can affect a whole stock market’s performance. A financial recession is one such example. Others include political volatility, interest rate fluctuations and even natural disasters. These all tend to impact the overall market rather than specific companies or sectors, but some areas can be hit worse than others, depending on the event.

The simplest way to minimise the threat of market risk is through diversification. A well-diversified portfolio that includes a range of different assets, such as bonds, equities, property and cash, can help reduce overall volatility and make sure that if one type of investment or region underperforms, gains in other areas will hopefully help offset these losses.

Sector risk

This type of risk concerns the dangers that can affect an entire industry. Specifically, it focuses on the risk that one event could cause the stock price of numerous companies in the same sector to fall simultaneously. For example, although rising oil prices can provide a boost for the oil sector and commodities-related stocks, they can also have a negative impact on the travel industry.

Again, choosing a diverse range of investments across several different sectors can help to counteract any risk impact on an individual industry.

Company-specific risk

Company-specific risk relates to factors that can affect the share price of a specific company or small group of companies. Examples of this type of risk include poor internal management, workforce strikes, company debt, or criminal activity.

As company-specific risk mainly affects share performance, it makes sense to build a portfolio that includes a broad range of company stocks, and the simplest way to achieve this is to invest via funds.

Inflation risk

Inflation can reduce the purchasing power of your money and, therefore, undermine the performance of your investments. In addition, a deflationary environment can also be threat to your portfolio.

An investment’s value without inflation factored in is known as its ‘nominal’ value. The most important measure of performance is the real return, which is the growth after inflation has been factored in.

To try and reduce inflation risk, you could think about investing in commodities such as oil, metals and gas. Commodity prices often move in the same direction as inflation rates. But rising commodity prices can also be a fundamental cause of inflation.

Currency risk

If you plan to buy shares in foreign companies or funds that invest overseas, movements in foreign exchange rates can have a significant impact on your investment returns.

For example, a falling pound will increase your gains from foreign investments in sterling terms, while a rising pound has the opposite effect, lowering the value of your returns.

If you do choose a foreign investment, it’s a good idea to make sure it forms part of a portfolio that also relies on investments that are bought, sold and provide returns valued in your own country’s currency.

Effective risk management

One of the best ways to manage all types of investment risk effectively is to build a diversified portfolio, which includes different investment types across a range of companies, industries, geographical areas and markets. If your investments are all concentrated on a particular industry or area, one change can have a significant impact on all your holdings.

A well-diversified portfolio will help to spread the risk so that even if one market performs badly, your portfolio’s overall performance should hopefully remain relatively stable. If you aren’t confident choosing investments, you should seek independent financial advice.

Focusing on long-term performance rather than being distracted by short-term setbacks can also help if your ultimate goal is to grow your wealth over time, rather than to receive a regular income. It’s a good idea to monitor your portfolio regularly to make sure it’s performing in line with your investment objectives and that you’re comfortable with your asset allocation, which will naturally change over time.

Remember, no matter what steps you take to reduce risk, the value of your investments can fall as well as rise. You may get back less than you invest.