Knowing how much risk you are comfortable taking is key
All investments carry some degree of risk. When you invest, you make choices about what to do with your financial assets. Risk is any uncertainty with respect to your investments that has the potential to negatively affect your financial welfare.
The term “Investment” can mean many things so it is really important that before anyone decides to invest their money that they are aware of the inherent risks. When discussing risk with clients we always look to explain the relationship between risk and reward of the different asset classes (cash, bonds, property, equities) through visually, through a series of illustrations.
Very often, when we meet clients for the first time, they are either taking on too much or not enough risk to support their long term objectives. By carefully planning, we can align their overall financial planning objectives with a level of risk they feel comfortable with.
For us, one of the biggest risks out there that is commonly overlooked is the impact of historic low interest rates on our savings. For anyone that is looking to save long term via term deposits or cash assets like premium bonds then more often than not this would not be suitable for them.
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. Each investment asset class carries a different level of risk. In order of low to high risk they are generally seen as; cash, fixed income, equities, property and other asset classes.
Concept of risk for return
As a general rule, the more risk you take the greater the potential for a higher return, but also the greater potential loss.
Risk for return is a general trade-off underlying nearly anything from which a return can be generated. Anytime you invest money into something, there is a risk, whether large or small, that you might not get your money back.
Investment goals and timescales
How you feel about risk 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.’
None of us like to take risks with money, 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. Risk varies between the different types of investments.
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 always 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.
Inflation and interest rates over time
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 diversifying investments over the long term. 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.
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.
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 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.
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 and also in the ‘bond’ market, where the pool of people who want to buy and sell bonds can ‘dry up.’
Currency risk is the potential risk of loss from fluctuating foreign exchange rates when investments are exposed to foreign currency or in foreign-currency-traded investments.
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.
INFORMATION IS BASED ON OUR CURRENT UNDERSTANDING OF TAXATION LEGISLATION AND REGULATIONS. ANY LEVELS AND BASES OF, AND RELIEFS FROM, TAXATION ARE SUBJECT TO CHANGE.
THE VALUE OF INVESTMENTS AND INCOME FROM THEM MAY GO DOWN. YOU MAY NOT GET BACK THE ORIGINAL AMOUNT INVESTED.
PAST PERFORMANCE IS NOT A RELIABLE INDICATOR OF FUTURE PERFORMANCE.