Investment risk explained

In general, stocks tend to sit atop the risk tree. But there is a huge internal range of risk on offer.

The maturity of a company, how sensitive it is to the economic cycle and the sector it sits in are just some aspects that can provoke a huge divergence in what risk really means in terms of stocks.

Biotech firms can pin their hopes on a drug and then find out after 10 years that it has failed trials. That’s not the same as a consumer-focused market leader targeting slow but steady growth in profits. It’s not to say risk is absent here but certainly different.

Although bonds tend to sit towards the bottom of the risk scale, there are a number of risks attached to them that investors need to be aware of.

Reinvestment risk, as we defined above, primarily affects bonds when there is the chance that the bond issuer can’t pay the loan back. Inflation risk is also applicable to bonds if inflation rises while the bond’s income stays fixed.

Bonds issued by governments tend to carry less risk than those issued by companies. However, less stable governments may have to pay an interest rate that is far higher than large and established companies.

The length of time until a bond is repaid also influences the price and its sensitivity to changes in interest rates. Typically, the shorter the time to maturity, the less sensitive a bond is to changes in interest rates.

Liquidity is the headline risk for property funds. Real estate investment trusts (REITs) can be different because they are traded on an exchange, so they don’t need to meet investor redemptions directly, like open-ended funds. But they still deal with the property market. And property is one of the most illiquid assets out there because of the time it can take to ultimately get your money out of it.

Commodities run a few risks. The first is the risk attached to supply and demand. That’s not something new to markets but if a sudden unplanned event like a hurricane wipes out vegetation or irregular weather yields a lower crop then there is likely to be volatility in the market.

The second has to do with how some investors access commodities markets. When derivatives contracts come into it and investors start to use leverage in search of amplified gains, they expose themselves to possible huge losses too.

It’s sensible to hold some commodities for diversification but wild speculative bets using derivative contracts can turn into a world of pain.

Inflation can really take the shine off cash. If you leave it untouched, cash will slowly become less valuable in terms of what it can be used to purchase in the real economy. If your savings rate doesn’t match the rate of inflation you are effectively losing money.

The main risk index ETFs are exposed to is market risk. As they seek to replicate broad market indices, anything weighing on those indices will likely have a similar impact on the ETF.

Thematic ETFs designed to track proprietary indices can be much more exposed to specific sectoral risk. If a particular sector is hit hard by an external influence, and stocks in that sector are the only holdings for that ETF, it follows that the ETF will be hit hard too.

Trust managers design their portfolios to take advantage of the opportunities they see in the market, while keeping risk to a reasonable level.

The majority of these are equity-heavy and away from measuring risk in the portfolio through sharpe, information and Sortino ratios, there is another type of risk.

It’s a much simpler one, namely the risk they get the stocks wrong. If there are 100 stocks on the index and a manager whittles that list down to what they deem as the best 30, there is every chance they miss out on gains elsewhere.

There is a trade-off here. ETFs can take this risk away but, by their very nature, will never allow you to beat the index as they are only ever designed to track it.

Special purpose acquisition companies (SPACs) are another way companies can come to the stock market.

They list as cash shells with the intention of acquiring a private firm and if they don’t find a target within two years investors simply get their money back. So there’s a risk that cash sits idle and then isn’t used.

Sometimes the journey is better than the destination in investing and the hype around what a SPAC might do can often entice speculative buys and more excitement than what it actually ends up doing.

Another risk is that investors just don’t know what they’re buying and there’s no guarantee you’ll actually like the firm it partners with.

Just because a stock is cheap does not necessarily mean it’s a bargain waiting to be snapped up. Many investors think penny stocks are their route to riches but there is a very real risk among new or unloved cheap stocks and that is the risk of outright failure.

For every household name there are thousands that never make it. Make sure you dig into the financials of the company instead of blindly looking for low share prices.

The artist formerly known as the Alternative Investment Market has produced some high growth stories like Fever-Tree and Boohoo. Some investors are drawn to the small cap index in search of growth but there are risks in doing so.

Companies choosing to list on AIM don’t have to meet the same criteria as what would be expected for a listing on London’s main market.

For example, they don’t need to publish an interim management statement in each six-month period of the financial year and there are relaxed rules on when they have to produce financial reports.

These more lenient rules are designed to make it easier for fledgling companies to list their shares. But some investors consider the range of differences to be emblematic of lower quality businesses with a lesser focus on corporate governance.

The legitimacy of cryptocurrencies is still a hot topic. But whether they are useful is a different question to how much risk they carry as an investable asset. Having been designed to be used as currency, they have mainly become used for price speculation instead.

This new paradigm and the real lack of substance to this side of their usage makes them a very risky prospect. Companies have earnings and revenues (and products) to show for their efforts, cryptocurrencies don’t, so ascribing a specific value to them is a pretty impossible task.

Some investors compare the likes of bitcoin to gold in that they use it as a safe-haven asset. But gold has industrial and ornamental uses beyond sitting in a vault. Crypto also tends to be far too erratic to warrant the ‘safe-haven’ label. It’s unclear what could really drive a crypto commodity market. For now, treating it as an asset remains a very risky proposition and investors should take extreme care when including them even in a diversified portfolio.