Embracing uncertainty – what you need to know about investment risk

When you hear the word ‘risk’ in the context of investing, your first thought could be in relation to losing money. It’s an understandable reaction – after all, no one likes the idea of their hard-earned savings falling in value. But investment risk is more than just the chance of loss. It’s also the reason investors can grow their money over time.

To make smarter investing decisions, it’s essential to look at risk from both sides: the potential downside and the potential upside.

If you can balance these two elements – rather than simply fearing one of them – you’ll feel more empowered to make decisions to support your long-term investing goals.

What is investment risk?

Investment risk can be described as the uncertainty of future returns.

This uncertainty can lead to negative outcomes – such as falls in the value of shares or assets, or lower-than-expected returns. But there are positive opportunities too – such as the potential for higher returns than cash and inflation over the long term, helping you to grow your wealth faster.

Without risk, investments wouldn’t offer the possibility of growth, both in terms of income and capital. If returns were simply guaranteed, they would stay low, like interest in a bank savings account over the long term.

Risk is what creates the possibility of:

• Compounding long-term gains
• Beating inflation
• Growing wealth faster than savings accounts
• Reaching long-term goals such as retirement or buying your first or next property

We are human beings, so we need to balance how we feel about risk with the return we need to reach our long-term goals, and the different types of investment risk.

Here are three questions to ask yourself.

1. What is your attitude to risk?

Your attitude to risk is personal to you. It is often described as your tolerance to risk, or how you might feel if an investment behaved in a certain way.

2. What return (and risk level) do you require?

When you’ve looked at your investing goals, you might have already calculated the long term return you require to meet them. This risk level might be higher or lower than your risk tolerance or attitude to risk.

The risk vs return trade-off describes how investors are rewarded for taking on risk through the possibility of higher returns. Lower risk investments tend to produce lower returns. As you move up the risk scale, you can expect higher potential returns, in return for a bumpier investment journey along the way.

• Low risk → lower potential return
• Moderate risk → moderate potential return
• Higher risk → higher potential return

3. What are the different types of investment risk?

Capital risk: This downside risk is what is on most people’s mind; the chance that your investment falls in value. This matters – and you’ll see AJ Bell give you reminders or warnings that investments can go down as well as up, but it’s only one part of the picture.

Inflation risk: Leaving money “safe” in cash may preserve capital, but over time inflation can reduce its purchasing power, in other words, what you can buy with it in the future. This is a hidden risk: your money remains stable in number, but weaker in value.

Opportunity risk: Choosing low-return options means you might miss out on potentially greater growth elsewhere. The impact can be significant over the long term and could reduce the chance of you reaching a long-term goal, such as a particular level of income in retirements from your pension(s).

While attitude to risk differs from person to person, generally younger investors can tolerate greater fluctuations in the value of their pension pot over the short term as they don’t need to access the money for decades. 

Volatility risk: Some investments fluctuate more than others. Volatility can be uncomfortable, but it doesn’t always mean a permanent loss – in some cases this might only be a short-term movement.

Managing risk

The goal isn’t to eliminate risk, and it’s rarely possible to do this as even cash can fall victim to inflation risk over the long term. The key is to understand and manage risk and your own investment habits and behaviours.

This involves you understanding your attitude to risk and managing this in line with the risk you might need to take to achieve your long-term goals.

If you are in interested in getting invested but don’t know where to begin, our investment ideas can help you get started.