Understanding investment risk Different types of risk

Capital risk

Pen lying next to a calculator

Capital risk will apply to all of your investments

Technically speaking, every investment carries at least some risk that you won't get back all the capital you invested. This is known as capital risk. However in practice some products are so safe that it's virtually certain you'll get what you were promised. For example, National Savings products and government bonds (gilts) are backed by the government.

Until recently we all thought we were pretty safe with our money sitting in a high street bank or building society, but that was before Northern Rock. However, despite the panic, Northern Rock investors were safe – even if the measures taken by the government to secure their safety were rather extreme and unusual.

The reality is that high street banks and building societies are forced to carry reserves and are monitored by the government. As a result, opening an account with a high street bank or building society is likely to be pretty safe for the foreseeable future.

And if the worst does happen (as it nearly did with Northern Rock), all authorised financial institutions in the UK are covered by the Financial Services Compensation Scheme so you would get at least some of your money back.

Inflation risk

Inflation risk is the threat of rising prices eroding the buying power of your money. This risk is greatest if you invest in savings accounts. 

Many savings accounts don't pay interest equal to the rate of inflation after tax, so even if you don't spend any of the interest, the 'real' value of your savings falls. If you spend the interest, the problem is even greater.

Shortfall risk

Shortfall risk means failing to reach your investment goal because the return on your investments is too low. For example, say you want to save £20,000 and can get a return of 3.4% after tax from a savings account. This means you'd have to save £140 a month to reach your target. If you can only save £100 a month, you'd need a return of 6.9%.

To reduce shortfall risk, you need to invest at least some of your money for a higher return but this may involve taking some capital risk.

Share-based risks

Pen and graphs

Share-based risks are a bit more complex

Specific risk

This is the risk that the company you've invested in performs badly. Some companies will fluctuate more than others. First time investors should be especially concerned to keep this type of risk to a minimum.

This could be done by building up less risky assets first - so if you buy share-based investments they'll have less effect on your overall portfolio. You can also reduce your specific risk by investing across a range of shares. This way, if one of them goes bust, or falls heavily, the overall effect on your portfolio is less.

The best and cheapest way to spread your risk is to invest in pooled investments like unit trusts or Oeics or investment trusts. They are called pooled investments because you pool your money with other savers to buy a wide range of shares.

Market risk

This is the risk of a fall in the particular country's stock market where your money is invested. When a market falls you will usually find that most shares are dragged down with it. Some fall by more than the average, some by less, but few will buck the overall trend.

A good way of avoiding market risk is to invest your money gradually, for example through a monthly investment scheme as this will smooth out big variations in the price.
You can reduce market risk by investing in many stock markets around the world. This works because not all stock markets will rise and fall together by the same amount, so if one crashes, you should be able to limit your losses because the others won't have fallen as much.

Currency risk

If your money is invested in stock markets outside the UK, then you will face currency risk. Wherever your money is invested, it will have to be converted into sterling when you want it back. As a result, movements in the exchange rate will affect the value of your investment - this can work in your favour or against you.

You can limit currency risk by diversifying, for example through an international fund that spreads its investments around the globe. Alternatively, you can avoid currency risk by sticking to the UK, but this increases your market risk.

Manager risk

There is a huge variation in the investment performance of individual managers of unit and investment trusts. It would be great if we could pick the winners in advance, but over the long-term very few managers manage to beat the stock market.

Investing through an index-tracking fund should remove the risk of picking a bad manager. Index trackers just try to follow their chosen index, such as the FTSE All Share or the FTSE 100. Index trackers tend to have lower charges than funds where managers try to beat the market. 

Find out .

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