Ultimately, investment risk is about how likely you are to get back less money than you put in. It’s not about how spikey the graph looks throughout the life of the investment, that’s volatility.
And, as much as we’d all like our investments to go up in a straight line, those ups and downs are the price we pay for the hopeful long-term outperformance of shares over cash.
Risk is much more black and white than that and different types of assets like company shares or bonds will carry different levels of risk. Then within those buckets there is a spectrum upon which companies and governments sit.
For investors the trick is to understand the potential rewards on offer and assess if the attached risk is worth it.
Why you should consider
risk when investing
Good long-term investing begins with assessing your
attitude to risk, your financial goals and how long you have
to get there.
Figuring out the relationship between these three elements will help you decide what to invest in. In this sense, risk goes a long way to informing what your portfolio will look like.
For example, if your investment goal is a £25,000 house deposit and you are giving yourself five years to get there with an initial lump sum of £20,000, you’d need to generate a 25% return over those five years.
If you were to lengthen the timeframe or reduce that goal, you’d put less pressure on your portfolio to produce
The result would be that you’d expect to hold higher risk assets in the first instance, because your goals require the potential for high reward (and risk and possible reward go hand in hand). Reducing the need to generate that level of return means you could afford to adopt a lower risk level and can choose assets potentially offering less of a reward.
This is a crude example but the point is we should always start with these three elements and work backwards to choose the assets we invest in. If your goals look overly ambitious and you aren’t comfortable exposing your money to the risk level you’d need to take in the hope of getting there, it’s much better to decide that from the outset.
This is the big trade-off every investor needs to understand when they start investing.
A good example of how risk and reward are linked is in government bonds.
Investing in them means you are willing to tie up your money for a number of years on the condition that you get regular ‘thank you’ interest payments for as long as your money is tied up.
If the government you are dealing with is deemed less stable relative to its peers, it’ll probably need to offer a higher interest rate than a somewhat safer country, to make it attractive enough for you to want to hand over your money.
That trade-off between the risk you choose to take and the reward on offer is the thread that runs through all
Market risk, sometimes called systematic risk, describes the possibility that something will affect the performance of an entire market. A specific event or a recession might hit all assets in a certain market at the same time.
The opposite of market risk. Instead of an event hitting the whole market, this considers how something can affect a single security, like a stock. This might be because of a particular problem in a firm and is the reason we diversify, so one problem doesn’t hit your whole portfolio.
Liquidity is a term used to describe a company’s ability to pay its debts without running into financial difficulties.
If a firm has a big loan to pay back and it’s looking unlikely that they’ll be able to meet those repayments it is experiencing liquidity risk.
If you choose to hold just a few stocks rather than being widely diversified, there comes the risk that any badly performing stocks will have a big impact on your overall portfolio. It’s a key reason why investors diversify their assets.
If you’re buying a bond you have to assess how likely it is that whoever you’re buying it from can repay you at the end of the term and provide interest payments along the way.
Understanding the ability of a government or company to pay you back can help you decide how much you’re willing to give them in the first place and how much interest you want along the way, to make up for the risk you’re taking.
If you have invested in a bond and it’s maturing, you might start to think about what to do with that money when you get it back. But if you want to reinvest it you might not be able to get the same rate of return on your new investment as you did on the old one.
For example, if you’re currently holding a bond that pays 5% interest and the rate on offer when you come to reinvest that money is 3% you might have to settle for that lower level of return.
If we were to simply stuff our savings under the mattress, in 10 years it would hopefully still be there but the value of what it could actually buy would be diminished.
Holding cash exposes savers to that inflation risk so investing with a view to at least matching the inflation rate can be appealing.
The theory here is that, if your money matches that level, your purchasing power in the real world is maintained. That step from saving to investing brings its own risks though (you’re currently reading all about them) so it’s not always helpful to compare the returns you can get from cash savings to those from the stock market.
How risky is my portfolio?
You can get an idea of the level of risk in your portfolio by comparing the weightings of the assets you hold. Holding more fixed income (bonds) and fewer equities (shares) usually means a lower risk profile, with a higher proportion of equities increasing risk levels.
It’s very important that you take into account your timeframe and goals here though. An equity-heavy portfolio geared towards funding your retirement in 35 years means something entirely different than the same portfolio geared towards providing a house deposit next year.
We all have different goals that require different time frames and levels of risk to get there. Working backwards from what you actually want from your investments can help decide what level
of risk to take, and what assets to hold.
Investors with this goal in mind typically want a low risk portfolio, maybe because the preservation of their money is more important to them than seeking growth.
This can be attractive for investors solely focused on income, maybe in retirement, as low volatility and relative certainty of returns are high up the priority list.
Income and capital growth
The prospect of growth comes into the picture more here. Income producing assets like bonds might be joined by shares which pay dividends but also offer the chance of capital growth.
Many investors used to bonds have felt the need to climb the risk scale into equity income since the financial crisis in 2008, as interest rates plummeted. Seeking a higher level of income than bonds can offer means accepting more risk in the stock market.
But one of the advantages of equities is that companies can pay out part of their profits to you as dividends and keep some back to put back into the business. If they can demonstrate that, when the firm reinvests in itself it produces even better profits, you might actually not want a dividend, preferring them to put that money to work instead.
This can be helpful if your goals mean you need to focus on the growth side, rather than income.
These portfolios tend to be equity heavy. This can suit younger investors with a long timeframe, like in pension accounts. That long-term view is important in this case as short-term kinks tend to look less menacing and create more of an upward trend over time.
As investors get nearer to their goals it can be a good idea to scale back the risk level here, to reduce the possibility of a sudden drop when it comes time to use those investment returns.
Risk and diversification
The main way investors will try to mitigate risk is through diversification. Holding a range of assets with uncorrelated returns and influences reduces the likelihood that one event will hit them all in a similar way.
For example, many investors will hold precious metals like gold as it tends to perform differently than stocks. Diversification is about having a squad of team mates with different skills, ready to perform for the good of the overall team.
Assets like stocks, bonds and even a bit of cash can play their part. Within stock holdings, it’s also important to diversify by geography and sector too.
Be careful of diworsification, though there is some research to suggest that, by the time you have added about 20 to 30 stocks in different geographies and industries to your portfolio, most of the reduction in risk that can be achieved has been done.
This doesn’t take into account the other assets you could possibly hold, like bonds, but is an important point to make. We can fall into the trap of thinking more is always better. But this brings in a risk of its own, namely that you start to introduce lower quality stocks into your portfolio and dilute the contribution your high performers can have.
What’s more, if you are actively choosing stocks, you could end up basically replicating the index, in which case it might just be less of a headache to buy an ETF index tracker instead.
Types of investments and
their level of risk
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 primarily affects bonds and then 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. many ISAs you can have.
REITs / Property
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.
What is the deadline for opening an ISA in the tax year 2022/23?
If you want to make the most out of your 2022/23 ISA allowance you have to open and contribute into an ISA account before the deadline at midnight on Wednesday 5 April 2023.
Any contributions made after this time will count towards next year's allowance, which means you could lose out.
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.
Crypto / Bitcoin
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.
Investment scams and how to identify one
If you are being offered high levels of reward, with low (or no) risk or a guaranteed huge reward on an asset it’s time to take a step back. You know what they say if something looks too good to be true.
Cold calls offering mouthwatering returns are nearly always scams and should never be trusted. Ask yourself: if this person were really this confident, why are they so eager to offer that chance to me instead?
If you are genuinely unsure of any investment make sure to check its legitimacy with the FCA or seek advice from a qualified financial adviser.
So, should you still be investing?
Investing starts with risk management. All investors should begin by assessing their attitude to risk, their goals and their time horizon and only then choosing assets to suit. Risk can be managed through techniques like diversification and the characteristics of the assets you choose.
But ultimately we can’t invest without it. If that is still a scary proposition for you, investing maybe isn’t for you. If you feel you can learn to manage risk and not let it keep you awake at night, it might be worth exploring.
This should not be read as personal investment advice and individual investors should make their
own decisions or seek independent advice.
When you invest, your capital is at risk. The value of your portfolio can go down as well as up and you may get
back less than you invest. Past performance is not a reliable indicator of future results.
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