Investing risk

It’s not often you can turn to Clint Eastwood for pearls of wisdom on investment strategy. But as he memorably said in the 1990s cop film The Rookie: ‘If you want a guarantee, buy a toaster.’

There are no guarantees when investing. But it's important not to view risk in a negative light only, because if there was no risk attached to investing, there wouldn’t be much in the way of return either.

Put simply, investment returns are your reward for taking investing risk. So while you should try to mitigate risk, you shouldn’t eliminate it completely. Because generally speaking, higher risks come with higher potential rewards.

Episode 10: What are the risks of investing?

Not all investments are made equal: some are riskier – and potentially more rewarding – than others. In this episode, our experts order investment types from safest to riskiest.

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What’s the relationship between risk and reward when investing?

There’s a basic relationship between risk and reward that all investors should know about. Lower risk investments tend to produce lower returns. And as you move up the risk scale, you can expect higher potential returns.

Just keep in mind that you may have to wait longer. Investing in the stock market is more volatile, which means in the short term you might see the value of your investment fall – potentially sharply. But over the longer term, the ups and downs of the stock market tend to even out, and can provide you with a higher return for the investment risk you’ve taken.

The relationship between investing risk and reward isn’t precise. Some investments with similar levels of risk will produce different returns. But the relationship broadly holds, and it’s a good way to think about investments. If you’re considering investing in a higher-risk asset, you should ask whether it offers potentially bigger returns that justify taking that risk.

Attitude to risk

An important first thing to consider is your ‘attitude to risk’. This is a commonly used phrase in the financial industry, but it can be a slightly bizarre concept to get your head around. After all, unless you’re one of those people who likes throwing themselves out of aeroplanes or climbing huge rocks without ropes, your attitude to risk is probably that you don’t like it.

But because of the relationship between investing risk and reward, your attitude to risk in the financial sphere should be a bit different. It may be more helpful to think about it more in terms of your risk tolerance. And this largely boils down to two factors.

The first is how comfortable you feel taking investment risk. For instance, if you couldn’t stand seeing your investment fall by 20% in a year, you almost certainly shouldn’t be invested in the stock market – because that can, and does, happen. Basically, if the risk attached to a particular investment is going to keep you awake at night, it’s not worth buying it. Especially because that sort of pressure is likely to panic you into making poor decisions.

The other factor to consider is your time horizon. How long until you need to access your money? Riskier investments tend to go up and down a lot, and though returns may be higher in the long run, in the short term you might incur a loss.

As a rule of thumb, if you have less than five to ten years before you want your money back, you shouldn’t invest in the stock market. The market is a fairly reliable provider of returns in the long term, but in the short term in can be remarkably fickle.

Diversification

One principle of investment you should be aware of from the outset is diversification. It’s one of the key ways to manage and mitigate risk.

Diversification basically means holding a wide range of assets, so you don’t have all your eggs in one basket. This is important because it lets you harvest returns while spreading your risk.

Consider, for example, the risk of holding shares in one company versus holding shares in fifty companies. If you invest in fifty companies and one of them goes bust, the impact on your portfolio is quite small. But if you invest in just one and it happens to go under, your entire portfolio has disappeared. That’s why diversification is the cornerstone of any investment strategy.

How to diversify your portfolio

Diversification can be easier said than done, because there are a number of ways to approach it. The most common way to diversify is – as in the example above – to invest in many different companies, so you aren’t too reliant on just a few doing well.

One common way to achieve diversification is by investing in a fund. Funds are pooled investments where your money combines with other investors and spread across anywhere between thirty and several hundred companies. As well as a convenient way to achieve diversification, funds save you from having to research lots of companies yourself (though they do charge an annual management fee).

There are other ways to think about diversification, depending on the investment strategy dictated by your risk tolerance. When looking at your portfolio as a whole, think about how diversified it is at a geographical level, so you aren’t too dependent on shares in one region or country. Similarly, you can achieve a more diversified portfolio by not overly concentrating your money in one sector: for instance, technology shares.

If you hold active funds, it may also be worth thinking about the diversification of investment styles of your fund managers – so they don’t all follow the same philosophy. And if you’re a more conservative investor and don’t want all your money invested in the stock market, you might consider diversifying across asset classes.

That means holding cash, bonds, gold, and property, for example, as well as shares. The benefit of a multi-asset approach is that different assets tend to do well at different points in the economic cycle. By holding a spread of assets, you’ll usually find you get a smoother journey.

Losses and volatility

As a way to measure investment risk, professional investors are somewhat transfixed by volatility.

In investing, volatility usually means the ‘standard deviation’ of returns – a statistical measure which calculates how widely dispersed investment returns are around the average. Essentially, the higher the volatility of an asset, as measured by its standard deviation, the higher the potential return you should expect to compensate you for the elevated investing risk you’re taking.

As you can probably tell, volatility is a fairly technical measure, and not one everyday investors will always have access to. It’s much more common to think about investing risk in terms of the losses you might sustain – which can be a more helpful way to think about it. It’s much easier, for example, to consider how you’d feel about losing 10% of your capital compared to experiencing volatility of 12%.

What risks are there when investing?

As well as thinking about risk generally, you may also want to consider specific risks in your portfolio. Though not exhaustive, the list below covers the main investing risks you may come across.

Market risk – the general risk you take by investing. This is the risk that you sustain losses because of the performance of the market as a whole, rather than specific bits of it.

Stock specific risk – the risk that a company you invest in goes bust or performs poorly. This can happen even if the rest of the market is performing well. You can mitigate stock specific risk with diversification.

Inflation risk – the risk that inflation eats away at your returns. Any financial asset you hold comes with inflation risk, but some are riskier than others. For instance, cash is seen as a safe asset because you (almost certainly) get your capital back. But the typically lower returns you’ll get by way of interest mean it has a higher inflation risk.

Liquidity risk – the risk you may not be able to withdraw your investment or turn it into cash when you want to. Liquidity risk varies by asset. For example, it's much easier to sell FTSE 100 shares than to sell property, where the market isn’t as liquid. Such assets are therefore said to have higher liquidity risk.

Reinvestment risk – the risk that you may not get the same level of return on your money after your investment matures, or on the interest you receive in the meantime. This usually applies to assets like cash products and bonds, which have a fixed lifetime and a set level of interest paid to investors. Let’s say you hold a bond paying 5% a year until 2030. The reinvestment risk is that by 2030, interest rates have fallen, and if you roll your investment over into a similar bond, you’ll only get 3% a year.

Default risk – the risk that one of your investments defaults on its obligations. Typically this applies to government and corporate bonds, which offer you a set rate of interest and your money back at the end. If they can’t pay you all the agreed interest, or the full capital sum at the end (usually as a result of insolvency), they’re said to have defaulted on their debt. Default risk can be mitigated by diversification, so that one default won’t have a substantial impact on your portfolio as a whole.

Active fund risk – the risk that an active fund manager underperforms the market. This applies to any fund whose manager takes an active approach – selecting a portfolio of stocks that differs from the market, with the aim of outperforming it. Again, you can mitigate active fund risk with diversification. With a good mix of managers with different approaches, if one falls behind, the others can hopefully take up the slack.

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