Why is investment risk important?
Whether you’re investing with a goal in mind, or simply saving for retirement, it’s important to understand risk.
Specifically, you should understand your own attitude to risk.
Some people are happy to live with calculated risks if it means the chance of a higher return in the long run; others don’t want to lose money under any circumstances. But being highly risk-averse can itself cause you to lose money.
Here we explain the different types of risk, whether you should be concerned and what you can do.
What are the risks of different investments?
The four main asset classes are cash, bonds, property and shares (equities), none of which are risk-free.
Cash is the least risky of the four but it tends to deliver low returns, which means the value of your money can be eroded in times of high inflation (see ‘Inflation risk’ explained below).
Find out more: cash as an asset class
One step up the risk ladder are government bonds, or gilts, followed by investment grade corporate bonds, where you effectively lend money to large companies in exchange for a fixed rate of interest. High-yield bonds, also known as 'junk bonds', are an even riskier option because they deal with companies seen to have a high risk of default.
Find out more: gilts and corporate bonds explained
Investing in commercial property, such as offices, supermarkets and warehouses, can grow your money through rental income and growth in the value of the property you own, but can be illiquid - meaning it can be hard to sell if you need to access your money.
Find out more: investing in commercial property
Shares, also known as stocks or equities, are seen as the riskiest asset class, as stock markets can be highly unpredictable. But some markets are considered riskier than others.
Investing in developed markets such as the UK and the US is considered relatively safe compared to other equity markets, although these contain their share of higher risk options, too, while emerging markets (such as Brazil, China and India) equities are likely to be more volatile.
Buying shares in geographical regions less-frequented by investors can be expensive and the shares can be comparatively illiquid.
Find out more: how to buy shares
Other types of investment are available, such as in commodities, cryptocurrencies and start-up companies, but you should be extremely careful with these. Scammers often use promises of rewards to lure in victims, while even genuine investments can be high-risk.
Use the FCA Warning List to check any investment ‘opportunities’ you may be offered.
How risky is my portfolio?
The proportion of asset classes in your portfolio largely determines how risky it is.
We’ve put together four Which? Investment portfolios, using a chili theme: the hotter chili, the higher the risk - and the potential for reward.
These portfolios don't constitute financial advice, but can act as a helpful starting point for a conversation with a financial adviser.
The portfolios are built for long-term growth - you'll need to invest for at least five years - and not designed for those looking to get an income from their investments.
- Find out more: how to build an investment portfolio
What else makes an investment risky?
Beyond the risks posed by the assets themselves, there are other risks investors should account for:
Inflation risk is the threat of rising prices eroding the buying power of your money.
This can be a particular problem if you’re retired, as your hard-earned savings will become less and less valuable in real terms.
With few savings accounts offering interest rates that keep up with inflation, taking on some risk by investing, with its promise of higher returns, could mitigate inflation risk.
Find our more: are you ready to invest?
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.
The key to avoiding specific investment risk is diversification.
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: how to diversify your portfolio
Market risk is where an entire stock market begins to fall.
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.
A good way of avoiding market risk is to invest your money gradually and invest for at least five years, giving your investments time to recover.
You can also reduce market risk by investing in a variety of stock markets around the world.
Find out more: investing a lump sum vs regular savings
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.
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.
There is a huge variation in the investment performance of individual managers of unit and investment trusts.
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, as these simply match their chosen index. Index trackers tend to have lower charges than funds where managers try to beat the market.
Find out more: active vs passive investment
What can I do about investment risk?
Following some simple rules can help you deal with investment risk.
- The greater return you want, the more risk you'll usually have to accept.
- The more risk you take with your investments, the greater the chance of losing some or all of your initial investment (your capital).
- If you're saving over the short-term it's wise not to take much capital risk. So what you are investing for and when you'll need access to your money will have a big impact on what types of investments are right for you.
- If you're investing for the long-term you can afford to take more risk as your money has more time to recover from falls in the markets.
- Investing in share-based assets has historically proved to be the best way for providing growth that outstrips inflation. There is a risk attached but, when you invest over the long-term, there is more time to recover your losses after a fall in the stock market.
Find out more: Fund supermarkets reviewed – our unique ratings of leading investment brokers.