With any investment, there is a risk to your return, the value of your capital or both. If an investment performs well you can make a profit, but if it performs badly there is the possibility of not making a profit, or losing some or all of your original investment. Generally speaking, the higher the risk, the higher the possible returns – but there is no guarantee. The aim of successful investing is to balance the risk you are willing to take with the returns available.
Deciding on your attitude to risk
Before you invest, decide how much risk you are willing and able to take. This will depend on two things:
- Risk Capacity: This is your ability to take risks, and relates largely to your circumstances and investment goals. Someone with a higher level of wealth and income and a longer investment term might be able to take more risks than someone with less wealth and a shorter investment term. This means that the first person has an increased risk capacity.
- Risk Attitude: This is your willingness to take risks. This is a personal preference, and has more to do with your personality than your financial circumstances. Some will be comfortable with the prospect of losing some or all of their investment in exchange for potential high returns; others will find this distressing and prefer to play it safe.
As a general rule, when investing in the short term it may be best not to take much risk, whereas if investing in the long term, your money can have more time to recover from market fluctuations and falls. So what you are investing for and when you are likely to need access to your money can have an impact on what level of risk is right for you.
Relative risk of different asset classes
Some types of investment are more risky than others. The four main investment classes are:
- Cash: Cash investments such as Cash ISAs and savings accounts are considered the least risky of the four, but tend to produce lower returns. This means that if inflation is high the value of your money can be eroded.
- Bonds: Government bonds are at the next level of risk, with investment grade corporate bonds – where you effectively lend money to companies in exchange for a fixed rate of interest – slightly higher on the scale. The risk is that the company you lend to could go bust.
- Property: This involves investing in commercial property, for example offices, warehouses and supermarkets, with the aim of growing your investment through rental income and increasing value of the property you own. This carries a slightly higher risk as the property market can fluctuate.
- Equities: Otherwise known as stocks and shares. This is generally viewed as the most risky asset class, as the value of your return depends on the stock markets, which can be highly unstable. Investing in UK equities is seen as slightly lower risk than US equities, with stocks and shares from emerging markets – such as China and Brazil – considered the most risky.
See the table below for more information on the specific risks associated with each of the main asset classes:
|Asset class||Risks||Potential benefits|
|Fixed interest (bonds)||
Types of investment risk
Your investment will be susceptible to different types of risk, depending on various factors including the asset class:
- Market risk: If the stock market of a country is experiencing a fall, it is likely that any investment made within this country will be affected. So, even if the specific company is doing well, a whole-of-market dip can bring your returns down. Therefore it may be worth researching well-performing countries as well as individual funds.
- Currency risk: This is the risk that a poor exchange rate will affect the amount you get when you redeem money invested abroad.
- Sector risk: Even if you are well diversified across countries and currencies, if you concentrate too much of your portfolio in one sector – say, technology stocks or mining companies – market forces may affect all companies in that sector.
- Specific risk: This is the risk that the specific company you have invested in does not perform well. There are ways to reduce this risk, such as choosing a pooled investment or government fund, which is unlikely to crash.
- Manager risk: If you choose to invest through a managed investment fund, there will be a manager who tries to predict the market and adjust the investments accordingly. This is why it can be a good idea to research managers before choosing a fund.
- Inflation risk: This is the risk that, as prices rise over time, the value of your savings will be eroded. To hedge against the effects of inflation, some investors choose to invest their money in equities (stocks and shares) instead of in cash. However this comes with the risk of losing some or all of your investment.
- Capital risk: This is the risk that you will lose some, or all, of the money (capital) that you invest. Technically, every type of investment carries this risk. For cash deposits, as long as the deposit taker is covered under the Financial Services Compensation Scheme, the first £75,000 of your money (per person, per institution) will be protected if the bank goes bust. Investing in stocks and shares does not come with this protection and it is possible to get back less than you invested.
Minimising risk: diversification
One of the main things you can do to reduce your risk when investing is to diversify your portfolio. Essentially, this means spreading your capital across a range of different investments so that if one fails, you don't lose everything. Diversification is often explained using the phrase "don't put all your eggs in one basket".
An investment portfolio can be diversified at two main levels:
- Between asset classes: as we've seen, different risks apply to different asset classes, so it makes sense to spread your capital between them. This could mean keeping most of your capital in lower risk investments such as bonds, with a small proportion invested in the stock market at higher risk.
- Within asset classes: as well as the general risks associated with each asset class, individual investments come with their own specific risks. For example corporate bonds come with the risk that the company will fold, and buying shares in a company or sector means that you could lose money if that company or sector performs badly. It's usually a good idea to invest across different sectors and companies to offset this risk.
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Last updated: 03 June 2015