Understanding investment risk

Thursday, 19 July 2018

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Independent investment advice from Wetherby IFA Wendy Cochran

Everyone knows that investments carry risk, but what does this mean in practice, and how much risk should you take?

Your investment time frame will determine your risk profile to some extent, as this has a direct bearing on your capacity to take risk. Risk capacity is also influenced by factors such as your age, wealth, and the goals you are saving and investing for. Your capacity for risk is likely to change over the course of your life as your personal circumstances change. If you understand the risks associated with investing and you know how much risk you are comfortable taking, you can make informed decisions and improve your chances of achieving your goals.

Risk is the possibility of losing some or all of your original investment. Often, higher risk investments offer the chance of greater returns, but there’s also more chance of
losing money. Risk means different things to different people. How you feel about it depends on your individual circumstances and even your personality. Your investment
goals and timescales will also influence how much risk you’re willing to take. What you come out with is your ‘risk profile’

DIFFERENT TYPES OF INVESTMENT
None of us likes to take risks with our savings, but the reality is there’s no such thing as a ‘no-risk’ investment. You’re always taking on some risk when you invest, but the amount varies between different types of investment. As a general rule, the more risk you’re prepared to take, the greater returns or losses you could stand to make. Risk varies between the different types of investments. For example, funds that hold bonds tend to be less risky than those that hold shares, but there are always exceptions.

LOSING VALUE IN REAL TERMS
Money you place in secure deposits such as savings accounts risks losing value in real terms (buying power) over time. This is because the interest rate paid won’t usually keep up with rising prices (inflation). On the other hand, index-linked investments that follow the rate of inflation don’t always follow market interest rates. This means that if inflation falls, you could earn less in interest than you expected.

MARKET TIMING RISK
Stock market investments might beat inflation and interest rates over time, but you run the risk that prices might be low at the time you need to sell. This could result in a poor return or, if prices are lower than when you bought, losing money. You can’t escape risk completely, but you can manage it by investing for the long term in a range of different things, which is called ‘diversification’. You can also look at paying money into your investments regularly, rather than all in one go. This can help smooth out the highs and lows and cut the risk of making big losses.

CAPITAL RISK
Your investments can go down in value, and you may not get back what you invested. Investing in the stock market is normally through shares (equities), either directly or
via a fund. The stock market will fluctuate in value every day, sometimes by large amounts. You could lose some or all of your money depending on the company or companies you have bought. Other assets such as property and bonds can also fall in value.

INFLATION RISK
The purchasing power of your savings declines. Even if your investment increases in value, you may not be making money in ‘real’ terms if the things that you want to buy
with the money have increased in price faster than your investment. Cash deposits with low returns may expose you to inflation risk.

CREDIT RISK
Credit risk is the risk of not achieving a financial reward due to a borrower’s failure to repay a loan or otherwise meet a contractual obligation. Credit risk is closely tied to
the potential return of an investment, the most notable being that the yields on bonds correlate strongly to their perceived credit risk. In practice, as long as you own investment funds which diversify your money across a lot of different companies or bonds then credit risk should be controllable, but in a financial crisis the value of bond funds can fall due to a sudden rise in the risk of companies going bust.

LIQUIDITY RISK
You are unable to access your money when you want to. Liquidity can be a real risk if you hold assets such as property directly, or even via direct property funds, and also in the ‘bond’ market where the pool of people who want to buy and sell bonds can ‘dry up’. For example, property unit trusts had to suspend dealing in 2008 and also after the EU referendum in 2016, meaning that investors couldn't get their money out when they wanted to.

CURRENCY RISK
You lose money due to fluctuating exchange rates. This risk is almost inevitable in a diversified portfolio, as the only way to avoid it is to hold all your money in UK assets, which isn't a great idea. However, it is a good idea to not hold the majority of your money overseas, as otherwise you are very exposed to the risk of the pound strengthening.

INTEREST RATE RISK
Changes to interest rates affect your returns on savings and investments. Even with a fixed rate, the interest rates in the market may fall below or rise above the fixed rate, affecting your returns relative to rates available elsewhere. Interest rate risk is a particular risk for bondholders.

These risks can be controlled with intelligent portfolio design, and the selection of an appropriate range of funds for your appetite for risk and financial circumstances. That's where we come in. We have years of experience of doing just that. Get in touch for more information and a free initial assesment of your situation.

Chartered Financial Planners. Regulated by the Financial Conduct Authority (FCA no. 603653).