Investment risk: An introduction

Here we look at the different types of investment and the risks involved.

Risk is an unavoidable part of investing, but it’s also a part of life. The price of goods changes, which changes the “spending power” of money, which is inflation. A pound will always be worth a pound, but its buying power diminishes every single year. Find out the different types of risk, which assets tend to carry less risk and how much risk you can tolerate.

Why is investing risky?

When you invest, you’re hoping that the value of your investments will rise over time and both outpace inflation and cover any fees you’ve paid to do so. The only reason investment works is because it is inherently risky — you’re wagering your money on the fact that your chosen company will rise in value. The potential reward usually matches the risk attached to an asset, so guaranteed rates, such as the interest rate on a savings account, are very low, as they hold very little risk.

Types of risk

An inescapable part of investing is that you cannot reap any reward without taking a proportionate amount of risk. There are a myriad of different types of risk:

  • Capital risk is the risk that the value of your assets will fall.
  • Inflation risk is the risk of your money losing purchasing 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 risk).

How risky are my investments?

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

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 to 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

Government bonds, also called gilts in the UK, are typically seen as the next-least risky asset class. A bond is essentially an IOU from the government or a company – you loan them some money and they’ll pay a set amount of interest over a set amount of time. Governments very rarely default on their bond payments so gilts are seen as safe, although they will fluctuate in value more than cash.

Corporate bonds

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.

Property

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

Shares are the riskiest and most volatile of the mainstream types of asset. You can also get “alternative investments”, which would include art, wine, cars and even watches, which would be riskier.

Share prices vary a lot, so there’s a real chance you’ll lose money. On the flip side, of all the assets we’ve covered here, they have the best chance 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.

Ready-made portfolio risk

If you choose to invest in ready-made portfolios, you’ll often choose one based on how risky it is. Sometimes these are labelled on a scale with terms like “Adventurous” or “Cautious” to explain the risks, other times they’ll go from 1 to 5 or 1 to 10, with the higher numbers the riskiest.

How risky a portfolio is determined by the weighting of some of the above asset types. If a portfolio has a large proportion of equities (shares), with low holdings in bonds or cash, then it’s determined to be quite risky.

Lower risk portfolios will have a lower stake in equities and a greater proportion placed into bonds or cash.

Some providers will give you some statements related to your risk profile, often asking you to choose on a scale between “strongly disagree” and “strongly agree”. It uses your answers to help understand how much risk you’re able to tolerate.

Questions may look something like the ones below. Investors that choose “agree” and “strongly agree” more frequently are more likely to be recommended higher risk profiles:

  • “When investing, I’m not worried about risk as it’s the only way to get good returns”
  • “I understand that my investments may fall due to negative market trends”
  • “I prefer to hang tight if my investments are falling in value, rather than selling right away”
  • “I feel anxious about my investments, so I often check in on them”

Fund risks

As with ready-made portfolios, funds have risk profiles laid out in the fund’s Key Investor Document. You can often download this document on the fund provider’s website. Here you’ll find the risk on a scale, usually from 1 to 7, with an explanation of the risks listed below.

How to reduce risk

The best way to reduce your risk is to diversify your portfolio. You do this by purchasing different investment types, such as government bonds, corporate bonds, equities, funds and potentially some commodities. You can also ensure that you’re diversified geographically, by holding equities and bonds from countries across the globe. When choosing equities, look into plenty of different sectors.

You can look at the breakdown of a ready-made portfolio and match its basic structure. For example, here’s the breakdown of some of Wealthify’s ethical ready-made portfolios. You could choose to match this, but change the individual holdings, such as by choosing equities that interest you.

What’s next?

Try to work out how you feel about risk – does the thought of falling investments make you feel a little queasy, or do you think you can manage it? Shares may be the riskiest type of asset, but you can always balance your portfolio with some government bonds, corporate bonds and some funds to give yourself plenty of diversification. Once you have a good idea of the risk you can tolerate, you’ll be able to choose investments.

All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest. Past performance is no guarantee of future results. If you’re not sure which investments are right for you, please seek out a financial adviser. Capital at risk.

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