What Is Investment Risk?
Broadly speaking, investment risk is the possibility of losing the money you invest or not making what you thought you would. The outcome is uncertain for several reasons:
Stuff happens in the world which de-stabilises markets.
The companies you invest in could hit the headlines for the wrong reasons.
Currency fluctuations could impact the value of your investment.
Governments can do things that can put the frighteners on markets.
There’s loads more but I think you get the point!
It’s human nature to crave certainty. So why take a risk with your money? Is it worth the hassle? In a nutshell, it could give your money the chance to grow over time, particularly better than inflation or cash.
Risk And Return Are Closely Linked
You can’t have one without the other. The lower the risk, the lower the potential returns. The higher the risk, the higher the potential returns. Although, what you can expect and what you actually get may differ greatly!
If you’d rather prioritise protecting the value of your money, you’ll have to sacrifice the prospect of greater returns. If you can get high returns and low risk, please tell me, I’m all ears!
Finding the balance between the highest possible return and lowest possible risk will depend on your attitude to risk and how long you can invest for.
Can You Tell How Risky An Investment’s Likely To Be?
When you invest in funds, you’re investing in a ready-made basket of investments which contain a range of investment types (also known as assets classes). The 4 main ones are:
Cash / money markets.
Fixed interest / bonds.
Property.
Shares / equities.
Cash is typically considered the lowest-risk asset type, and shares / equities the highest risk.
Different funds have different risk profiles which give you a good idea of how bumpy the road’s likely to be. Funds with the lowest risk profile are the least volatile and funds with the highest risk are the most volatile.
If you’re a cautious investor, you may only want to take a small amount of risk to try and achieve a modest but relatively stable return. If so, funds with a low risk profile could be right for you.
If you’re comfortable taking more risk, you might want to go for funds that have a higher volatility to give you the potential for higher returns. If so, funds with a higher risk profile could be more suitable for you.
Lower risk funds have, however, not delivered much in the way of safety recently. A lot of that is due to what’s been happening with the bond markets but I don’t want to get too technical here!
Can Investment Risk Be Managed?
While investment risk can’t be eliminated, it can be managed, to an extent.
You could spread your risk by putting your money in a range of investments. That way, if one loses money, it could be balanced out by your other investments. This is called diversification and can be an effective method of risk management. Lots of eggs in lots of baskets!
The easiest way to diversify is to buy into a multi-asset fund which contains many investments (rather than just one) so they can be less risky than buying individual shares in a single company. This is generally the approach I adopt with my clients but I’m not saying it’s ALWAYS the right way.
How Does Time Affect Risk?
The level of risk can reduce over time. A longer time period is typically associated with lower market volatility and risk.
Investments should be seen as a medium to long term commitment. This means, you should be prepared to hold them for at least 5 years to give your money the best chance to grow.
Ideally, you should have an emergency fund (3 to 6 months’ worth of living expenses) before you start investing. That way, if the markets have a wobble, you won’t have to sell before your investment has chance to recover.
The time you have to reach your goals (known as your time horizon) can also affect the level of risk you could take. The longer your time horizon, the more risk you can afford as you’ll have more time to recover from any market downturns.
When you’re young, for example, you can afford to place your retirement savings in a more aggressive portfolio. As you get closer to retirement, you may be more cautious with your investments as you’ll have less time to ride out any turbulence.
Your goals can also affect your attitude to risk. With a school fees fund, you’re saving for a fixed amount so you may want to be cautious with the risk you take. Whereas with a ‘Ferrari’ fund, the return is more important than the money so you could afford to go all-out adventurous here (one can dream, right?).
What Does All This Mean For Me?
At the end of the day, it’s your money and you need to be fully aware of the risks involved so you can be comfortable with those risks. You need to go in with your eyes wide open!
As a general rule of thumb, you should only invest if you’re comfortable with a degree of uncertainty over the outcome.
I know you probably know this but, nevertheless, sometimes it needs to be repeated. There are NO guarantees when it comes to investing but, as I’ve hopefully, shown, there are things you can do to smooth the ride.
Until next time!...