Investing risk - balancing risk and return

Investment risk shouldn’t hold you back from investing for the first time. It creates the possibility of beating inflation and growing wealth faster than in savings accounts. Despite the risk, investing can also help you reach long-term goals such as retirement or buying property.

What is investment risk?

Investment risk is more than just the chance of loss, it’s also why people invest in the first place – to achieve returns that can grow their money over time. Without risk, investments wouldn’t offer the possibility of returns that might come in the form of income or growth. If returns were simply guaranteed, they would stay low, like interest in a bank savings account over the long term.

Officially, 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 and meet your goals.

Investing risk vs reward

The basic relationship between risk and reward is that lower risk investments tend to produce lower returns. Towards the lower risk end of the spectrum are cash and bonds, which offer some protection from market volatility – in other words the ups and downs in the market from one day to the next. But that protection works both ways – you may miss out on the highs as well as the lows.  

And as you move up the investment risk scale – with shares at the higher risk end – you can expect higher potential returns. Just keep in mind that you may have to wait longer.

Investing in the stock market can be a bumpy ride and you might see the value of your investment fall, potentially sharply, in the short term. 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.

It’s not an exact science; 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 yourself whether it offers potentially bigger returns that justify taking that risk.

How much investment risk should I take?

We’re human beings, so we need to balance how we feel about risk against the return we need to reach our long-term goals.  

Here are two questions to ask yourself.

1. How does investment risk make you feel?

This is often called your attitude to risk or risk tolerance. It’s personal to you but it aims to define how you might feel if an investment behaved in a certain way.  

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 money falling in value. But it’s likely you appreciate the need to take some investment risk over the long term, to give you a chance of growing your wealth.

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

When you’ve looked at your investing goals, you might have already calculated the long-term return you’d need to meet them. The risk level needed to achieve that might be higher or lower than your risk tolerance or attitude to risk suggests on paper.

This where your time frame is also important. Anything you know you’ll want to access in the next five years or less you may want to keep as cash, as low risk as possible from an uncertainty point of view.

But for long term goals where you’re targeting a higher potential return, you might consider allocating more of your money into stock market assets, like funds that contain a higher weighting of shares.

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. 

What are the different types of investment risk? 

This list isn’t exhaustive but aims to cover the main investing risks you may come across. 

• Capital risk – This is what’s on most people’s minds; the chance that your investment falls in value. Some investments can fluctuate more than others. 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 amount, but weaker in value.
• Opportunity cost – 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 retirement from your pension.
• Liquidity risk – The risk you may not be able to withdraw your investment or turn it into cash when you want to. This can vary, even within different asset types. For example, it's much easier to sell FTSE 100 shares than to sell shares on smaller exchanges like the Aquis Stock Exchange, where the market isn’t as liquid and there is much less trading history.
• 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, so that one stock doesn’t have a substantial impact on your wider portfolio.
• Default risk – The risk that one of your investments doesn’t meet its obligations. This typically 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, they’re said to have defaulted on their debt. Diversification is also a way to mitigate default risk.