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Investment risk explained

Getting to grips with risk is essential before you start investing.
Investment risk explained
Updated
April 23, 2021

Risk is something we all have to deal with when we invest. But it’s probably one of the most misunderstood concepts in investing. The very word can sometimes put people off the markets altogether or induce unhealthy habits akin to gambling as opposed to sensible investing. That’s why it’s so important to understand what investment risk actually is.

Getting to grips with how it fits into the investing equation is not just important for your own sanity, it’ll make you a better investor and help you match your own personal financial needs to the mix of assets you choose to hold.


What Is Investment Risk?

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. 

It’s 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 - some are inherently riskier than others because of a range of factors. 

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

A lot of investors start their journey by looking at which stocks to get into. But that’s not the best first step.

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 (10% of the average cost of a UK home) 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 those returns.

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.

Considering risk also helps with portfolio diversification. If one of your portfolio holdings is a new company in an untested market, it might be that it goes on to be a revolutionary world leader. It’s also possible that it dies out completely. Understanding this can help you decide how much money to allocate to that opportunity and how much to put in more consistent, stable companies. The latter might not make you a millionaire overnight but they are also more likely to be there when you wake up. 

This is the big trade-off every investor needs to understand when they start investing.

 

Investment risk types

Market risk

Risk analyst Nassim Taleb is famous for talking about so-called ‘black swan’ events. These are rare and unexpected incidents that tend to have far-reaching consequences.

Market risk, sometimes called systematic risk, describes the possibility that something will affect the performance of an entire market. That might come as a result of a specific event or a recession and you can’t really get round it through diversification, as it assumes everything is hit at the same time.

The opposite to market risk is unsystematic risk. Instead of an event hitting the whole market, this considers how something can affect a single security. This might be because of a particular problem in a firm and is the reason we diversify. Should something hit one company in the portfolio, being diversified can reduce the impact that has on the overall asset mix you hold.

 

Liquidity risk

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.

Liquidity risk can be present in stock markets too. Open-ended property funds are a good case study here. Because these funds tend to invest in commercial property and huge buildings, if investors suddenly choose to withdraw their money, the fund can find it difficult to actually get that money to them quickly. 

That’s because the assets they hold aren’t very ‘liquid’ meaning they can’t sell them and turn them into cash very quickly or easily. There have been a few times over the past few years that this has happened and these funds have had to suspend dealing, while they sell off assets to meet redemption requests.

Small cap companies with few interested investors might also experience liquidity risk. You might want to buy their shares but if there are no sellers that becomes quite difficult. That might become more of a concern if you need to sell quickly and find that you can’t. Larger companies with a much bigger pool of investors constantly buying and selling their shares tend to carry less liquidity risk.

 

Concentration risk

If you choose to hold just a few stocks rather than being widely diversified, the impact that any one asset can have on your overall portfolio can be significant.

Some investors prefer this because they don’t want their best performers to be held back by lower quality assets elsewhere in their account. 

But with that potential for returns comes the possibility that any badly performing stocks will have a similar big impact in the opposite direction.

Concentration risk is the reason a lot of investors choose to diversify their holdings. If an event pops up that affects a stock, sector or even a whole asset class in your portfolio, the idea is that this can be mitigated by other holdings with different and uncorrelated external influences.

 

Credit risk

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.

Credit analysts regularly interrogate companies’ accounts to assess the likelihood that investors won’t get their money back. But credit risk exists outside of financial markets too.

When you apply for a loan of a mortgage, banks and building societies will assess how much credit risk you carry with you. That’s why they want to know the ins and outs of your financial position. They’re trying to figure out how likely it is that you’ll default on the loan. 

That helps them decide how much they’re willing to give you.


Reinvestment risk


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.

One way to mitigate the impact of reinvestment risk is to use a process called laddering. This is where investors spread their money across a number of bonds with different maturities to limit the chance of your money being exposed to changes in interest rates.

An example might be an investor putting equal sums of money into bonds maturing in one, two, three, four and five years.

Each year, they might take the money from the bond that matures and reinvest it in another bond that matures in five years. In doing this, they are trying to make sure they are only exposed to one year’s worth of interest rate risk at any given time.

 

Inflation risk

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. It’s the reason your favourite childhood snacks are probably 10 times more expensive now and it’s also the reason many savers become investors.

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.

Simple comparisons can miss out the importance of that elevated risk in the stock market.

 

Why are some assets riskier than others?

When you’re investing, you’re choosing to swap the relative certainty of cash for the possibility for returns. The extent to which you are willing to do this should be reflected in the assets you choose and, luckily, there are assets out there to suit everyone. 

The reason assets like shares and bonds carry different levels of risk is simply because of the possible returns they can provide, coupled with the differing likelihoods that you might lose your money en route.


Risk-reward concept

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 financial assets.


How to understand your risk appetite 

We all have different goals that require different time frames and levels of risk to get there. It can help to see a few examples of the risk profiles some investors subscribe to. 

It might be that they fit you exactly, or you might see elements of yourself and your goals in a view. In any case, it can be a useful starting point from which you can refine how you view your own unique risk tolerance.


Conservative

Investors in this bucket 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 as low volatility and relative certainty of returns are high up the priority list.


Moderately conservative

The prospect of growth comes into the picture more here. Income producing assets like bonds might be joined by equity income 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.


Moderately aggressive

The balance tends to tip here, with equities outweighing bonds and growth overtaking the focus on income. Equity income is still important here - dividends make up a huge part of overall total return. 

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.


Very aggressive

These portfolios tend to be equity heavy. This can suit younger investors with a long timeframe, maybe 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 that money.


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 and fewer equities 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.


How to mitigate risk when investing in the stock market

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.

 

High-risk investments

It’s useful to think about risk in terms of certainty. New companies in new markets or new sectors can provide little certainty as to their success as they often don’t have comparable competitors etc. but a brand new idea can also offer huge opportunity. 

With that, investors have to accept there is also the possibility of outright failure. Again, as you increase that certainty you start to slowly rein in the potential reward. 

An example here might be Amazon. In the early days few could have foreseen the behemoth it has become. Investing back when Jeff Bezos had hair required a high tolerance for risk and the knowledge that, ultimately, the firm might not work out. But for that investors will have been exposed to high reward.

Repeating that stellar growth from here seems unlikely but then again, the risk that Amazon will fail completely as a business also seems unlikely.

It’s important to remember though that for every Amazon there are a thousand that didn’t make it. 


Low-risk high-return investments

This is the one every investor wants. But it’s a rarity because the actions taken to drive further profits can often be entrepreneurial or pioneering in a certain industry. If no-one has done it before that brings in the risk that it might not work. 

But balancing that is often the hope that the possible returns from exploring a new strategy could be substantial. That’s why you’ll most often have to put up with increased risk levels if you want the potential for high rewards.


High-risk high-return investments

When you accept there might be a high level of risk attached to exploring a company or investment idea that could potentially provide high returns, there are a few other things you might have to accept too.

One is volatility along the way, another is the time it might take for this to play out. If your company takes a lot longer to actually deliver, how does that affect your personal goals? How do you feel about possibly having to put that house deposit on hold? 

A third element is how those companies mature themselves and tackle their own hurdles.

ASOS getting stopped at US Customs and not being allowed through with their products is part and parcel of a less mature company finding its way. 

Investors should be prepared for challengers to possibly run into rough patches that established incumbents have overcome already.

 

Medium-risk investments

You might see balanced portfolios out there whose managers consciously keep bonds and equities together to keep risk to a medium level. These suit investors who want access to the potential for growth but who aren’t hell-bent on seeing huge returns.


Low-risk investments

All investment carries risk but some assets are deemed relatively stable, like government bonds, and can be useful for investors at the low end of the risk spectrum.

If income or capital preservation is your goal these can come in handy. It might be that your financial goals are coming up soon and you need to take risk off the table in order to be able to meet them.

 

Risk and diversification

Diversification can be used to spread risk. But be careful of diworsification.

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

Stocks

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 like Unilever targeting a slow but steady growth in profits. That’s not to say risk is absent here but certainly different.


ETFs

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.

 

Investment trusts

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 that 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. In the search of index-beating returns managers will not so much try to identify winners as weed out potential laggards. 

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.


Bonds

Although bonds tend to sit at 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 the inflation rate diminishes the returns associated with the bond.

 

Cash

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.

IPOs

The risk of an IPO comes in how the market treats the shares at the time. Some company IPOs produce an initial pop as excitement builds that the company has joined the stock market. But there’s also the risk that investors feel its valuation at launch can’t be justified. In that instance, the shares can suffer heavy losses. 


SPACs

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

Investors can overlook the risk attached to them because if a company doesn't find an acquisition target, investors simply get their money back. But even if they do find a company to merge with, there is the chance they can drop when that acquisition happens. 

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. You may put money into the SPAC before it explores a merger but there’s no guarantee you’ll actually like the firm it partners with. 


REITs / Property

Liquidity is the headline risk for property funds. REITs can be different because they are traded on an exchange, so they don’t need to meet investor redemptions directly. 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

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.


Penny stocks

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.


AIM

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 do not 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 lower focus on corporate governance joining the market.

 

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 as a store of value. This new paradigm and the real lack of substance to this side of their usage makes them a risky prospect.

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. It’s unclear what could really drive a crypto commodity market. For now, treating it as an asset remains a very risky proposition.



How risky is it to invest in emerging markets?

Favourable demographics in the form of young and increasingly educated populations as well as already evident GDP growth in countries like China form the basis of many emerging market investment theses.

As countries industrialise and go through waves of wealth creation, consumption and domestic stability, companies can spring up to serve nascent middle classes with new products and services designed to meet local consumers’ needs.

In this sense, countries experiencing high growth can lay the foundations for companies serving their populations to grow quickly too. 

Developed economies can rarely offer this opportunity for growth on a similar scale or timeframe. But with that opportunity comes risk. It’s easy to fall into the trap of thinking every new emerging market company will be the next Alibaba or Tencent but the reality is most won’t. And the gap between the haves and have nots can be considerable.

 

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 start 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.

Important Information



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