Risk means different things to different people. How you feel about it depends on your individual circumstances and even your personality.
If you want to plan for your financial future, it helps to
understand risk. 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 like 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 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
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.
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.
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
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’.
You lose money due to fluctuating exchange rates.
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.