Whether you’re saving for a specific goal or growing your business wealth, it’s important to understand investment risk. While being risk-averse might make sense at first, it’s important to examine the relationship between risk and reward.
What is investment risk?
In finance, risk describes the chance that an investment’s real-life gains differ from an expected outcome. When you invest in riskier financial instruments, the chances are higher that you will lose part or all of your investment.
While low risk investments reduce the chances of losing your initial investment, it’s also often the case that higher risk investments potentially provide higher returns. This is why it’s important to understand the types of risk involved before investing.
Are there any risk-free investments?
No investment is free from all possible risk, but some are considered riskless because any risk is more theoretical than practical in nature. These are useful to analysts because they form a baseline for measuring the risk of other investments.
Examples of relatively risk-free investments include:
Certificates of deposits (CDs)
Government money market accounts
UK Treasury gilts
Options like Treasury gilts are considered nearly risk-free because the UK government would need to default in order for you to lose your money. It’s not out of the realm of possibility, but in practicality this is very unlikely.
Types of risk
Systematic risks impact the market as a whole and include things like macroeconomic factors and political risk. Socio-political changes, currency rates, inflation, and interest rates all affect your portfolio. More industry or company-specific risks are called unsystematic, and they can be caused by things like product recalls or regulatory changes.
In addition to these broad types of risks, there are more specific investment risks to consider.
Business risk: Will the company generate enough revenue to be profitable? Business risk takes factors like cost of goods, competition, and product demand into account.
Credit risk: Will the borrower be able to pay back its debt obligations? If you invest in corporate bonds, you should assess the risk of default on these debts.
Country risk: Whether you’re purchasing government-backed bonds or investing in mutual funds, look at the country’s level of risk. Emerging markets carry a higher risk level to more established treasuries. There’s also risk associated with exchange rates, as one currency might depreciate more than expected.
Interest rate risk: Interest rates have an impact on many types of investments, particularly bond values. When interest rates rise, bond prices will fall as a result, for example.
Investment risk levels
If you want to diversify your portfolio, it’s a good idea to invest in a mix of high, low, and medium-risk investments like the following.
In addition to the relatively risk-free investments we’ve listed above like government bonds or gilts, there are also low-risk investments like cash to consider. Buying cash and leaving it in a savings account is low risk, but it does deliver lower returns and you run the risk of inflation decreasing cash value. Property also carries a lower risk, offering rental income and growth in value.
Investment grade corporate bonds are medium-risk investments. When you purchase a corporate bond, you’re essentially lending money to a large corporation in exchange for fixed interest rates.
If you’re looking for another medium level of risk, you might want to invest in gold and silver. Gold prices do fluctuate but it’s considered safer than playing the stock market. Silver is more volatile than gold, making it a higher risk.
High risk investments
While government bonds are low-risk investments, high yield or ‘junk’ bonds are considered high risk. These are issued by companies with a high risk of default, meaning there’s a chance you won’t get your money back.
Stocks and shares qualify as high-risk investments because the stock market is notoriously unpredictable. There is some variation between markets, however. Emerging markets in countries like India or Brazil carry the allure of reward, but they are more volatile than developed markets in the UK.
Cryptocurrencies are further examples of high-risk investments because their values rise and fall dramatically over short periods of time, making them quite volatile. They’re also not covered by the Financial Services Compensation Scheme.
How to offset investment risk
When looking at how to manage investment risk, the most important factor to consider is diversification. It’s very important to diversify your portfolio with different types of securities in multiple industries. While some may carry more risk than others, when one volatile market falls, you’ll be kept afloat by your more secure investments.
You should also look at the long vs. the short term when investing. If you’re playing a longer game, you’ll have the space for prices to recover from any sudden market dips. While share-based assets carry more risk in the short term, they also provide the opportunity for more growth over time. Diversification takes all of this into account for maximum reward.
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