For many people, the word ‘investing’ is associated with the word ‘risk’. But to what extent is this true? What are the risks involved – and when are those risks worth taking?
Many savers are reluctant to take their money out of cash accounts and venture into investments such as stocks & shares. It’s true that risk and investment are joined at the hip – but what does ‘risk’ actually mean in this context? Understanding financial risk can be the key to gaining control over it, and even making it work in your favour.
Here are some examples of financial risk and their implications for you as a potential investor.
Risk of investing in the wrong things
Perhaps one of the major deterrents for would-be investors is the risk of doing the wrong thing. The whole process can be daunting, littered with hundreds of different options and a lot of new terminology. It’s no wonder that many people are put off at the first hurdle.
Fledgling investors should start small. In particular, avoid investing in single companies until you have a lot of experience behind you. Instead, spread your investments across a collection of companies, which you can do through vehicles such as a unit trust or an OEIC (open ended investment company). You can also invest in these kinds of funds via a stocks and shares ISA, which gives you a further advantage by sheltering your gains from most tax. The main reason to invest in a broad range of companies (rather than just a few) is that you are spreading the risk more widely. It is up to the fund managers of the individual funds to monitor the individual companies and the markets as a whole, for which you pay a small fee.
Once you have taken the first steps and have gained some confidence, you may start to develop your investments into new directions. It’s a good idea to discuss your plans first with a financial adviser to get their views.
A number of external risks may have an effect on the performance of your investment portfolio. Firstly, there’s the risk associated with the underlying economy, which is often factored into the price of shares. Related to this is political risk, for example from political decisions around the world, which can quickly impact the price of shares and funds. Both of these are outside of your control and will therefore always be present in varying degrees.
Thirdly, there is the performance of the individual companies in which your portfolio is invested. This is within your control to an extent, as you can do your research and make your own selections. Remember that you can always disinvest in certain companies or funds if you choose to do so.
Risk of investing at the wrong time
Another worry you may have is of taking out an investment at a ‘bad time’ – such as just before a dip in the market. Or you may be waiting to make your move, hoping to buy just before a big boom. The truth is, trying to time the markets or make predictions will only ever bear fruit half of the time (if that) – and for the majority of people, this is not sustainable.
In reality, the ideal time to start investing depends only on you and your goals. If you put off making a start, all you are really doing is putting your own plans on hold while your cash savings erode. In most cases it is best simply to take advice, do your research well, then take your first steps.
Risk is inherently part of investing. If you look at the bottom of any regulated financial product, it will always state that ‘you may get back less than you invest’. The key is to understand the extent of this risk and to weigh it against the product’s potential advantages. This is where your attitude to risk comes in.
Attitude to risk
As a financial adviser, one of the things I have to determine when working with a client is their attitude to risk. Every individual is different, and will take their own personal view on what they are comfortable with money-wise. Attitude to risk helps to determine the right investment approach. There are 3 elements to consider here:
- How comfortable are you personally with risk? This is about how cautious/bold you are in your life generally.
- How much risk you can afford to take? For example, you would consider how much money you could hypothetically afford to lose before it affected your lifestyle.
- What are your financial goals? How much growth would you need to achieve, and over what timescale?
By assessing all three elements together, a financial adviser can help you work out your true attitude to risk – sometimes called your ‘risk tolerance’. This may turn out to be greater or less than you believed it to be. The higher your risk tolerance, the more you can consider investments that could deliver potentially higher growth. Conversely, a low risk tolerance might mean favouring more stable investments such as bonds. As a rule of thumb, higher risk means higher potential returns (but also a greater chance of loss).
Risk and returns always go hand in hand, so be wary of any product that promises returns way above cash – particularly if it doesn’t explain the associated risks.
The risk of not investing
One area of risk that often goes undiscussed is the risk of not investing. Although the rate of inflation – the rate at which prices increase – has recently fallen, it is still higher than the interest rate you will receive in the majority of cash savings accounts. This means that over time the spending power of your money will diminish, so in effect you are constantly losing money. This in itself is a risk.
In order to fight the effects of inflation, it may be necessary to seek out a way to make your money grow faster. This generally means some form of investing.
So yes, investing does carry a risk – but so does not doing it. And if you are planning your finances in the longer term, then investing is likely to be a risk worth taking. Remember, if you have a workplace or private pension then you already have money invested in the markets – so branching out into another form of investment really isn’t such a big step to take.
The key is to find the level of investment risk you’re comfortable with. You can then balance this risk against your long-term goals to determine how best to make your money work for you.