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Understanding risk
All investments carry some sort of risk, so it’s important to be aware of how your money could be affected. Not all risk is equal, so the potential for gains or losses may vary from one investment to another.
Before you start investing, it’s important to know the type of risk associated.
In this guide, you'll learn
- There are different types of investment risks that can have varying effects.
- Understanding what risk is in finance could help you work towards your longer-term investment goals.
- How to approach investing to mitigate risk where possible.
What is investment risk?
Risk refers to the possibility of your investment losing value. As a rule of thumb, a high-risk investment usually comes with a higher potential return, but a greater chance of losing value. A low-risk investment may offer a lower potential return, but with that comes less probability of it going down in value.
When deciding to invest your money, you’ll need to consider your tolerance to risk. Naturally, some people may feel less comfortable with the idea of their investment losing value. Others might be more willing to accept that in the pursuit of greater returns.
You might also be in a financial position to risk more or less capital than others. This is known as your capacity for loss.
Factors affecting risk
There are different factors that may affect the level of risk on your investments. Each one can impact performance in its own way. These include:
Investment time frame
The longer an investment is held, the more time it has to build back after fluctuations in value and recuperate any losses. This means that a higher risk, higher return investment might be better suited to a long-term outlook. Similarly, a short term to medium-term investment doesn’t may not have the time to recover, so you may decide to go with a lower risk strategy.
Income
Income plays a pivotal role in determining how much risk you’re willing to take. If you’re relying on your income for immediate needs, then investing may not be for you. Â
Your income can also determine your risk capital, which is the amount of money you’re willing to trade or invest without affecting your lifestyle.
When determining your tolerance to risk, you need to consider how much money you have got, minus any liabilities like debts or other financial obligations. Generally, the more disposable income a person has, the more risk they may be comfortable in taking on.
The wider economy
When comparing investment opportunities and weighing their potential benefits and risks, it can be useful to keep one eye on the economy at large. For example, you may want to consider economic factors such as inflation and interest rates when preparing your investment strategy.
Inflation can reduce the buying power of your money, meaning the real returns on financial investments are weakened. It could also affect how much other aspects of investing cost, like transaction charges or entry and exit fees.
Global events
While rare, and often unpredictable, global events can affect large regions of the world. These events can have a ripple effect across countries, continents and beyond. This in turn may have a severe impact on financial markets, and therefore investments. Global events affecting investments include, but are not limited to:
- Political instability
- Military conflictsÂ
- Pandemics and disease outbreaks
- Weather catastrophes
Many global events are unpredictable by nature, meaning it’s often hard to account for them however you choose to manage investment risk. To prepare as best as possible, investors might want to simply be aware of the types of events that could impact investment performance – even the less obvious ones.
Other contingency measures include maintaining a well-diversified portfolio to help your investments cope with times of uncertainty. It’s also sensible to make sure you have access to shorter-term cash funds should the need arise, reducing the chance of ‘panic selling’.
Types of investment risk
Every investment action naturally involves some form of risk, and an associated return. Some different types of investment risks to consider when looking at an investment opportunity include:
Interest rate risk
Interest rate risk involves the value of an investment potentially changing after an unexpected fluctuation in interest rates. This type of risk tends to affect the value of bonds more directly than stocks. When interest rates rise, bond prices tend to fall – and vice versa.
However, because the returns on savings accounts are closely linked to interest rates they would tend to perform better in this case.
Inflation risk
Inflation risk refers to the potential loss of buying power as a result of a rise in the prices of goods and services. When these costs increase at a higher rate than predicted, it can lead to a decrease in purchasing ability for the same quantity of money.
As the real value of money diminishes gradually, investors might look to revise their strategy and take a longer-term approach to their financial planning, helping their investments recover from these any fluctuations and give their investments more time to grow.
Capital risk
Capital risk is the chance that all or part of an investment is lost, especially where there is no guarantee of a full return of investment, this applies to most investment types.
Diversifying your investment portfolio can help to spread capital risk, although it’s worth bearing in mind that lower risk investments typically have the potential to offer lower returns.
Market risk
Market risk refers to investment risks that can impact an entire economic market, or a large part of it. Your investments may risk losing value due to political and other macroeconomic factors affecting the overall performance of that market.
While you can help mitigate capital risk by simply diversifying your portfolio, market risk is best offset by investing in different international markets too. This could mean investing in bonds in one high interest region while opting for certain commodities in another part of the world. Not every market is affected by factors in the same way, meaning a more global approach to your investing could help to minimise these risks.
Business risk
Business risk simply refers to how viable a commercial operation is. It focuses on whether a business can generate sufficient revenue from sales and services to cover its operational expenses and turn a profit. Operational expenses can include:
- Administrative expenses
- Rent
- Production costs
- SalariesÂ
Business risk may be influenced by factors such as:Â
- Competition
- Market demand
- Profit marginsÂ
- Pricing of goods
Credit risk/default risk
Credit risk refers to the potential of a borrower defaulting on the principal or interest payments of their debt obligations. This risk is often a concern for investors who have bonds in their portfolios.
Government bonds usually have the lowest default risk but may yield lower returns. Such bonds are considered ‘investment grade’. On the other hand, bonds with a high chance of defaulting but a much higher yield are known as ‘high yield/junk’ bonds. A balanced portfolio will often look to combine assets of different risk levels.
Political risk
Political risk relates to an investment losing value due to political changes or instability in a country or region. This type of investment risk can arise from:
- Changes in government or leadership
- Foreign policies and activity
- Legislative changes
Political risk might not present itself regularly, but can become a bigger factor the longer an investment is held.
Managing risk in investment
Despite its unpredictability, there are some approaches which may help manage and mitigate your risk of investing. These could include:
1. Keeping a longer-term focus
Investments usually fluctuate over time. However, the longer you invest, the greater the chance of your investments riding out these ups and downs in the market. That’s why it could be helpful to keep your assets or capital invested for 5 years+.
Your ‘time horizon’ is the period you’re prepared to wait until needing your money/assets back, which can also affect your investment risk. The longer your time horizon, the more time your investments have to recover from any market downturns. This in turn can affect your appetite for risk.
2. Diversify
The most common strategy for minimising risk is by diversifying your investment portfolio. You can start by spreading your portfolio across different investment options such as:
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Cash |
Some investors might want to dedicate a relatively low percentage of their portfolio to cash and cash equivalents. This is a common way of adding stability to your investments. |
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Stocks and shares |
A share of ownership within a public business or company anywhere in the world, and it may include payments to shareholders if the company makes a profit. |
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Bonds and gilts |
A bond is a form of debt issued by a company or government in order to raise money. A gilt is a fixed-interest product issued by the UK government, which can be bought and held by investors for the long term. |
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Funds |
Funds are a collection of assets or capital from different investors, pooled together and distributed across a wide range of investments. This can help spread the overall investment risk. Common types of funds include mutual funds and exchange-traded funds (ETFs). |
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ETFs (Exchange-traded funds) |
ETFs allow investors to track the underlying asset of a specific market, helping to diversify investments overall. For example, this could mean the FTSE100, giving exposure to the stocks within that index, or it could be a global ETF which tracks stocks across number of markets worldwide. |
|
Property |
Property within an investment portfolio refers to any real estate bought for the purpose of generating some level of financial return. It’s worth bearing in mind that the value of this type of investment will be affected by ups and downs in the property market. There is also an element of liquidity risk when it comes to property. This means it can be difficult to convert property assets into cash, especially during a downturn in the market. |
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Commodities |
Commodities refer to a special class of assets, such as:
They may also include ‘soft’ or perishable commodities that cannot be held for long periods, such as cotton or sugar. |
3. Breaking up your investments
When deciding how to invest, you usually have a few options:
- Investing a lump sum
- Investing smaller amounts regularly
- Or a combination of both
The second option is known as ‘pound cost averaging’, which involves making investments on a smaller but more regular basis. Some of these investments will cost more, whereas others might be bought at a lower price. The aim of this is to smooth out the peaks and dips created by market volatility.
High risk vs low risk investment
Depending on different risk factors, such as income and timeframe, you might want to consider a high-risk or a low-risk investment.
Let’s look at the features of each type:
Low-Risk
Returns tend to be much smaller, but you’re less likely to lose your capital/assets. Losing capital is a risk with all forms of investing.
Pros:Â Low-risk investments could make your investment portfolio more stable as they are less susceptible to market volatility.
Cons:Â On their own, low-risk investments may not contribute as much to growing the value of your portfolio.
High-Risk Investment
Investments can lead to bigger returns, although there’s a higher chance of losing most, if not all of your capital/assets.
Pros: High returns can help you build your wealth faster and achieve your investment goals. They can also help you keep up with inflation.
Cons: The uncertainty and unpredictability of these investments may pose too much uncertainty, and a greater chance of losing value.
Which investment is better?
It depends on your investment goals and attitude to risk. High-risk investments can offer bigger rewards, and have a better chance of returns over time, but low-risk investments can be less volatile and more predictable. Approaches like diversifying your portfolio and pound cost averaging can be important in spreading your investments and softening the impact of market ups and downs.
Key takeaways
Investment risk frequently asked questions
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An investment may be high risk if it exists in a volatile market, targets a high rate of return, and there’s a greater chance of losing all your capital/assets.
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There are several methods to identify and calculate investment risk. While often complex, they attempt to take into consideration things like associated risk, historical ups and downs, geopolitical and macroeconomic factors, and even the risk of a given company or portfolio.
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It depends on your investment goals, your attitude to risk and your time-horizon. If a stable investment over the long term is more important to you, low-risk options may offer that at the expense of more limited opportunity for growth. On the other hand, higher risk investments can be more appealing to an investor looking for the potential of higher returns, but with a greater chance of investments going down in value. A mixture of both, high risk and low risk investments is key for creating a week-diversified portfolio.
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It’s generally a good idea to keep your assets or capital invested for at least 5 years. This gives your investment time to grow over the medium to long-term. It also allows for investments to recover from ups and downs in the market.
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There’s no way of avoiding risk altogether, although there are ways of mitigating it. For example, looking to diversify your investments can help to spread risk across different asset classes, industries and markets, giving you more stability in unpredictable times.
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Important legal information
The Lloyds Bank Direct Investments Service is operated by Halifax Share Dealing Limited. Registered Office: Trinity Road, Halifax, West Yorkshire, HX1 2RG. Registered in England and Wales no. 3195646. Halifax Share Dealing Limited is authorised and regulated by the Financial Conduct Authority under registration number 183332. A Member of the London Stock Exchange and an HM Revenue & Customs Approved ISA Manager.