What is investment risk?

16 October 2020

8 minute read

How to reach your financial goals while understanding the risks.

Who's it for? All investors

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek professional independent advice.

What you’ll learn:

  • The more risk you take the higher the potential returns – and losses.
  • Keeping cash under the mattress is not zero risk.
  • How to manage risk by diversifying.

What’s investment risk – and how to make it work for you

If you’re thinking of investing, you’ll need to consider whether or not it’s right for you. This will depend on your personal circumstances and you need to consider factors such as how much you have in cash savings; whether you have any debts; your general financial security; what your financial goals are and how long you’re looking to invest.

However, as well as all of these, the other really important thing to think about is investment risk because investments can fall in value as well as rise so you may lose money. Investments can all fall in value and, in the most extreme situations, you can lose all that you invest. 

But what does risk mean and how does your position differ to the next person’s? What effect will your attitude to risk have on building your wealth?

Meaning of risk 

We all have friends – or maybe it’s you - who tend to order the same thing each time they dine out at a particular restaurant. This is often an unadventurous option, such as fish and chips.

They are averse to taking any risk with trying something different. 

For the cautious diner the reward is knowing what they’ll get – no surprises, no upsets – and possibly not much excitement for their taste buds either.

Adventurous friends will try out the specials each time – however outlandish. Whether it’s grilled grasshoppers or spicy pig’s trotters they get a thrill from trying something new.

Equally, some people avoid standing near the window when in a high building, while others are happy to take on work as a skyscraper window cleaner. 

So it is not surprising we have different attitudes to investment risk when our approach to life’s varied risks also differ. And when it comes to investing, the main things you need to think about are how you’d feel if there’s a period of stock market volatility and the value of your investments are going down and up, potentially quite significantly or if they simply went down and the prospect of their recovering looked bleak. Also, you should consider if you needed to sell some of all your investments and they were worth less than when you bought them.

Your attitude to risk will be affected by your particular circumstances, what experiences you’ve had if you’ve already invested – good and bad - and when you expect to need the money in the future.

So how do you harness risk in such a way you neither miss out nor lose your shirt?

More risk, more returns – hopefully

The simplistic equation for investing is that on average, the more risk you’re prepared to take, the higher the likely returns – but also the greater your possible losses. You could lose everything.

Another way of putting it is the less risk you’re prepared to take the less you’re likely to gain – although you’ll possibly lose less if things don’t work out. 

If you think doing nothing removes risk altogether, then you’re very much mistaken. Keeping your cash under the mattress is not a no-risk approach. The reality is the purchasing power of your hoard will simply reduce each year due to the impact of inflation. You might end up better off in cash is if deflation takes hold, though. This is the opposite of inflation and can happen when the economy weakens and prices fall, meaning the purchasing power of your cash increases. Deflation is rare though – the last time it occurred in the UK was in 1960 – but it’s possible that it could happen again in the future so it’s worth being aware of. 

Crucially, lack of action means possibly not being able to attain your goals in the time you have available. 

Risk is a little like exercise

You could think of risk like a way of getting fit. If you prefer not to do your daily workout you may struggle to reach your fitness goals. Equally, if you exercise too rigorously in too short a time you could do yourself an injury.

The answer for your physical self is to try exercise steadily – perhaps doing more strenuous workouts as you grow fitter and more confident. 

With investing, the initial build-up means starting with a level of risk that you feel comfortable with and adapting your view depending on how your personal circumstances, financial goals - and confidence – change.

Whatever your position on risk, there are some basic principles that can be wise to stick to:

Short-term goals

If you’re putting aside money for something less than five years away, such as a wedding or house deposit, then cash is best. If you opt for the stock market, which will rise and fall over the period, there’s a higher chance that your investment will be worth less than you put in at the very time you need it.

Long-term goals

If you’re looking five to 10 years ahead or more, say to help with a child’s university costs or your retirement, then cash is likely to be the poorer option, especially if savings rates remain low. Your pot will retain its face value but over the period there is the chance that inflation will eat away at its real worth. This is when investing is worth considering, remembering there’s always a chance you might lose money.

One of the main reasons why share prices have moved up over the long term is that as well as being linked to the performance of specific companies, they’re also linked to the underlying economy which might grow over time. Corporate bond prices will also be supported by company performance, although they are also highly sensitive to changes in interest rates. 

How to manage risk

Cash foundation

Building a cash cushion is your first step to reducing risk - so that you won’t be tempted to dip in to a stock market investment if an emergency strikes. If the market fell just at the moment you needed the money, you’ll probably take longer to get your investment goals back on track.

Give yourself time 

The more time you have on your side the more you risk you’re likely to be able to withstand. And if you are looking decades ahead and dreaming of a golden retirement, you’ll likely have more chance of achieving it if you can invest in riskier shares than keeping your money in cash. 

Markets fall as well as rise but like any journey on a bumpy road, it is a more comfortable ride if you keep your eyes on the horizon – in this case the financial goals you’re aiming for. The worst thing to do when a market falls is to panic and sell your investments because you simply lock in the losses. Remain invested, and with time on your side you’ll hopefully recover from any losses along the way though, of course, that isn’t guaranteed; that’s the uncertainty of investment.

Diversify, diversify, diversify! 

Not many people carry eggs around in a basket these days, but you get the picture that this is likely to lead to serious breakages.

Spread your investments around in different places and you’re more likely keep more of them safe – or if some do go wrong, others should hopefully do better and so balance your risk.

Think about investing across different types of assets, including shares and bonds, business types and countries. A popular way to do this is using funds – where a fund manager pools your money with that of other investors and uses their expertise to purchase investments in what they believe to be the best companies to meet their particular investment strategy.

A good mix of investments gives you the chance of a more comfortable performance and the level of returns that will help you meet your goals (hopefully) as well as the chance of a comfortable sleep at night.

What next?

If you understand the risks you are happy to take and know where you want to put your money take a look at Smart Investor, which offers thousands of funds to choose from. 

Perhaps you want to narrow down the choice? If so, you can find inspiration from our Funds List. This is a selection of carefully chosen funds that our experts have pinpointed for their robust processes and solid reputations. See our funds list here.

If you know you want to invest but need help spreading your investments according to the risk you are happy taking, then consider our Ready-made Investments. You can choose to invest your money in one of five blends of funds across a range of assets that most suits your situation and attitude to risk. 

If you’re not sure if investing is right for you at all, or would prefer someone else to make your investment decisions for you, you could try our Plan & Invest service. You tell us about yourself and then, if we decide that you’re ready to invest, our experts will select and manage your investments for you, taking your attitude to risk into account.

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