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Risk explained

What you'll learn

Investing your money can offer better returns for you than cash savings, but this means more risk. Please remember the value of your investments can fall as well as rise. You may get back less than you originally invested.

When deciding how to invest your money, you should try to understand the level of risk involved and how much you're comfortable with. It's also important to think about how long you want to hold your investment. It's a good idea to invest for at least the medium to long-term: at least 5 to 10 years.

What is risk?

When you’re thinking about investing, you'll need to be clear about how you feel about risk and how able you are to take losses. Some of us are very unsettled by the idea of the value of investments falling. Others are happier to take the risk of ups and downs in the stock market.
 

Your attitude to risk

A number of factors affect how able you are to accept the risk of losses. These include how long you plan to invest, your age and health, your income level, your investment goals, the source of your money, and how much of your total assets are invested. For example, if your investment is funded by an unexpected windfall, you may be willing to accept a higher level of risk than if you were using your life savings.

Types of risk

To get the most out of your savings ideally you want to beat inflation with higher returns than you might get from a normal savings account. We appreciate that you want to do this at a level of risk you're comfortable with.

Generally, the more risk you take, the greater the potential rewards, although this is not guaranteed. But everyone feels differently about risk, so here’s an overview of the main points to consider:

1. Interest rate risk

If you save your money in a fixed rate account you might earn less interest than the market average if savings rates rise. On the other hand, if market rates fall, your fixed rate might be higher than others that are offered.
 

2. Inflation risk

It's likely that you know how inflation affects your money. Imagine if you put money in an account earning 2% interest per year, but inflation was at 3% over the same time. Your original investment increased in value but its buying power went down by 1%.
 

3. Capital risk

As a general rule, if you aim for higher returns you must be willing to take a higher risk. This is because where higher returns can potentially be earned there is also a greater chance of a drop in the value of your investment.

You need to find a balance between the risk to your capital that you can cope with and the returns you need to reach your investment goals.
 

4. Market risk

This is the risk of a fall in the stock market of the country where your money is invested. When an index such as the FTSE 100 falls, most shares usually fall too. Some by more than the average, some by less, but a few will buck the overall trend.

You might think about investing gradually, such as on a monthly basis, to smooth out big changes in the price you pay. Or if you’re investing over a period of at least five years there may be time to recover from any market losses. It’s important to remember that you may not get back the original amount you invested if investment markets fall.
 

5. Performance risk

Similar funds may vary in how they perform due to differences between assets selected by each fund. Funds aiming for high performance may vary more than those with a more cautious approach to investing. How well a fund performs in the future is a question that can be estimated, but not known with complete certainty.

Spreading your risk

Asset classes and diversification

An asset class is a category of investments, or economic resources, that shares typical features and behaves in a similar way. Each asset type has its own level of risk and return and will perform differently in any given market environment.

1. Cash

Cash deposited in banks or building societies earns interest and is the least risky asset type. Its buying power can fall over time due to inflation.
 

2. Bonds and Gilts

Bonds and Gilts are loans to companies and governments respectively, and are also sometimes known as fixed-interest securities. They pay interest at a fixed rate over a fixed term. The original loan amount is also repaid at the end of the term. They tend to be classed as lower risk than shares but their value can be affected by the financial strength of the company or government that issues them. Interest rates can also affect their value.
 

3. Property

Investing in property can be direct or indirect. The second of these could be a Unit Trust invested in commercial property, for example. Overall, the risks and potential returns tend to be higher than for bonds or cash. However, property is a limited market and the time needed to buy and sell can mean that property takes longer to cash in.
 

4. Shares

Owning a share of a company will earn a share of any income or capital paid out. They tend to carry a higher risk than the asset classes listed above. Share value can be affected by changes inside the company and also in the markets they trade in. However, shares also have the potential to deliver greater returns.
 

5. Commodities

Physical goods such as gold, oil or crops. They often carry a higher risk than shares because their prices can be harder to forecast, as prices rise and fall due to unpredictable events such as natural disasters and political unrest. However, because their prices can move differently to other assets it can make sense to invest in these alongside shares and bonds as they can help to balance your portfolio.
 

6. Diversification

You may not want to put all your eggs in one basket. Investing in a range of assets in different sectors and markets can help to balance out the ups and downs of the stock market, as any poor performance by some investments may be offset by gains in others, which may reduce the risk of loss.

Investing in managed funds can be an easy way to build a diversified portfolio as they tend to include a variety of asset types.

Risk v reward

Investment comes with some risk – the question is, how much risk are you comfortable taking as you reach for your goals?

New to investing

Still hungry to learn? Access our ‘Boost Your Skills’ articles to give you a good understanding of the basics.

Ready to invest?

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