What is 'specific' risk?
If you invest in individual company shares, there's always a chance that unforeseen events will scupper your portfolio. Some shares will fluctuate more than others, but no company is completely immune to volatility.
Shares will often move in line with the market, or in line with those of similar companies, but sometimes circumstances unique to a company will emerge, prompting investors to sell shares. A sudden sell-off will lead to a lower share price.
BP is a good example of a big company whose share price took a major dip after an unexpected event, when the Deepwater Horizon oil spill in the Gulf of Mexico wiped 40% from its value in 2010.
This disaster had a unique impact on the fortunes of BP, leaving shareholders to reassess the merits of what many had previously viewed as a solid, reliable investment.
How do I overcome specific risk?
The key to avoiding specific investment risk is diversification.
You can reduce your specific risk by investing across a range of shares. This way, if one company goes bust, or falls heavily, the overall impact on your portfolio is reduced.
The best and cheapest way to spread your risk is to invest in pooled investment funds, such as unit trusts or investment trusts. They're called pooled investments because you pool your money with other savers to buy a wide range of shares.
Find out more: Different types of investment – find out more about pooled investment funds.
What is market risk?
Market risk is the risk of a fall in the particular country's stock market where your money is invested. If sentiment turns against UK shares, for example, share prices could start to fall across the board, even if the prospects for particular sectors or companies are unchanged. 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. Similarly, if you're investing with a time horizon of at least five years then there should be opportunity to recover from any market losses.
You can reduce market risk by investing in a variety of 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.
Find out more: Which? investment portfolios – we have created a unique set of investment portfolios that can help you decide where to invest your money, balanced with how much you're willing to put at risk.
What is currency risk?
If your money is invested in stock markets outside the UK, you'll 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.
If the foreign currency depreciates against sterling then when you convert it back, you will incur a loss.
Let’s say for example, you bought £10,000 worth of units in a US investment fund, while the exchange rate was at US$1.5 to the pound, you would get US$15,000 of investments (ignoring commission).
If the dollar weakens and the rate was US$2 to £1 when you converted back to sterling then, assuming your investments hadn't grown, you would only get back £7,500. If, however, the dollar strengthened and became on a par with the pound, then you would get £15,000 back, from your original £10,000.
You can limit currency risk by diversifying, for example through an international fund that spreads its investments around the globe, or by hedging your position – ie, investing in currency related investments to ensure that you never lose additional money due to movements in the currency.
Some funds that invest overseas do the hedging for you. Alternatively, you can avoid currency risk by sticking to the UK, but this increases your market risk.
What is manager risk?
There is a huge variation in the investment performance of individual managers of unit and investment trusts. It would be great if you could pick the winners in advance, but over the long term very few managers beat the market on a consistent basis.
So while some of the best fund managers may consistently beat their benchmarks and deliver the kind of returns that you hope for, they're extremely difficult to pick.
Buying an index-tracking fund should remove the risk of picking a bad manager. Index trackers just try to match 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 more: Active vs passive investment – find out more about the two styles of investing.