Investment risk: An introduction
Here we look at the different types of investment, and the risks they carry.
Risk is an inherent part of investing, but it’s also a part of life. You don’t get anything done if you only worry about avoiding risk.
Just thinking about money, risk is inescapable. Take out your wallet and pour a few coins into your hand – you probably have an idea of what you can buy with them. Maybe a bar of chocolate, maybe a pint. But even those small metal disks are risky things that change in value. The price of goods changes, inflation reduces what your money can buy from year to year, and so on. A pound will always be worth a pound, but its buying power could diminish.
When you invest, you’re hoping that the value of your investments will rise over time and both outpace inflation and cover the fees you’ve paid to whoever handles your assets. But the only reason investment works is because it is inherently risky. Share prices vary over time, dividends grow and are cut, bond yields rise and fall, companies soar in value and go bust.
Types of risk
An inescapable part of investing is that you cannot reap any reward without taking a proportionate amount of risk. There are myriad different types of risk:
- Capital risk is the risk that the value of your assets will fall.
- Inflation risk is the risk of cash losing buying power.
- Counterparty risk is the risk of an organisation defaulting on its debts.
- Specific risk is the risk of something unforeseen happening to a specific company.
- Shortfall risk is the risk you won’t have enough money (which could be because you didn’t take enough, er, risk).
Types of asset
Different asset types are generally perceived to carry different levels of risk – and correspondingly, different levels of potential reward. Let’s take a closer look at the main asset types below.
Cash is seen as the least risky asset, because although its value does change through inflation, or relative to other currencies, its buying power within the UK will tend stay fairly static. But remember the risk/reward trade-off – if you earn any interest on your cash it will be quite low, and likely not enough to outpace the erosive power of inflation.
Government bonds, also called gilts in the UK, are typically seen as the next-least risky asset class. A bond is essentially a loan you make to a government or company, on which it pays a set amount of interest over a set amount of time. Governments only very rarely default on their bond payments so gilts are seen as safe, although they will fluctuate in value more than cash.
Next up the risk-o-metre are corporate bonds. These are more risky than government bonds because companies are more likely to go bust and default. Bonds from larger more established companies are known as investment-grade bonds, while those issued by smaller, less established companies are known as high-yield bonds because they have to pay a higher rate of interest to attract buyers. The higher the yield, the riskier the bond.
With property, usually commercial property if it’s held in a fund, you have the opportunity for two types of gain: capital gains, when the value of the properties rises; and income payments from the rent you get from tenants. The property market rises and falls unpredictably, but property is a bit of a wild card in terms of where in the risk scale it fits.
Shares – also known as equity – are the riskiest and most volatile of the mainstream types of asset. There are of course other assets you could buy – art, wine, cars – that would be riskier, but those are generally not for beginners. Share prices vary a lot, and there is a real chance you’ll lose money. But equally, equities provide the best chance, of all the assets we’ve covered here, of maximising your capital growth. UK shares in particular are also good at paying dividends – a share of the company’s profits paid out to the shareholders. Using dividends to buy more shares, a process called reinvesting, is a powerful tool for growing your portfolio.
Which investment is best?
Whenever you invest, you are taking on risk. The more risk you take on, the more you stand to gain – but the more you could also lose. More risk also means the value of your portfolio could change more dramatically and less predictably.
If you think you will need your money in less than five years or so then investing might not be a good idea for you. However, if you plan on locking your money away for a long time, you will have more time to gain back any losses you might make, and more chance of accumulating a greater amount of wealth than you would have if you’d kept it in cash, where it would be subject to the erosive effects of inflation.
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