We all take a certain amount of risk in life. An existence with no risk would likely be a rather boring one. But it always pays to learn about the risks we might face. Understanding risks helps us avoid them, or else manage our behaviour to try and control them.
When it comes to investing it’s no different. As I pointed out in my recent article, embracing risk can lead to better long term returns. But learning about the key risks associated with each of your investments is vital in order to see what could go wrong. It could also help you act rationally if things don’t seem to be going to plan.
Below I outline some of the main risks associated with investing. It’s not an exhaustive list, but covers some of the main things to think about.
Market risk (risk of loss)
This is probably the risk people most associate with investing: that your chosen asset will fall in value. Market risk applies all assets apart from cash, which keeps your capital secure. Various other risks (including some of the ones below) contribute to this broader risk, and the type of asset you choose will dictate the extent of this risk. Typically equities (or shares) are the highest risk in this regard.
This is the risk that changes in currency exchange rates cause the value of an investment to decline. Changes in exchange rates can mean you lose money even if an asset rises in value in its local market. This risk applies to all overseas investments (unless action known as “hedging” is taken to offset the effects), but is particularly relevant when either your local currency is volatile, or when the overseas asset is in a particularly erratic currency. Emerging markets currencies tend to be highly sensitive and often fluctuate a great deal, as does the Japanese yen.
Country / political risk
Localised events such as natural disasters can have an obvious impact on economic growth, while politics can play a significant role, particularly in the shorter term. The outcomes of elections, for instance, can dictate sentiment and influence market direction, though predicting these – and the market response – is fraught with difficulty.
High profile events such as elections can move markets but there can also be other changes. Policy regarding regulation, taxation and government spending can all influence a nation’s economy and impact sectors and companies to varying degrees.
In a stable, democratic nations country risk is (usually) less of a concern. However, in other nations such as emerging markets these risks can be much higher. Political instability or financial troubles are typically more likely, and could weaken a country’s financial markets. In addition, these markets may be less mature, less well-regulated and prone to move significant price movements.
The success of any investment in an individual company – either in shares or bonds – will clearly be shaped by that company’s fortunes. There are various risks and opportunities faced by every company, but smaller companies in particular can be less mature, well-diversified or financially able to cope with changing circumstances.
An investment that is difficult, expensive or time-consuming to buy or sell is known as “illiquid”. Dealing may take some time, or you may have to accept a low price if you want to exit. In exceptional circumstances, may not be possible to sell at all. Property is a good example of an illiquid asset. Following the EU referendum in 2016 a number of commercial property funds suspended dealing as redemptions by investors overwhelmed the funds’ ability to sell assets in an orderly manner. Others imposed charges on those exiting to reflect the additional costs involved in dealing.
Inflation is a measure of the rate of increase in general prices for goods and services. The most familiar measure in the UK is the Retail Price Index (RPI). The risk inflation poses is the erosion of value or purchasing power of your capital. Professional investors often talk about generating a “real return” on their investments, that is to say a return above inflation. If you generate less it means going backwards in terms of spending power.
Short fall risk
Short fall risk is a possibility that your portfolio will fail to meet your longer-term financial goals. It can be a risk derived from with taking too few risks! For instance, if you never invest and only ever put money aside in cash, your savings may not grow sufficiently (see inflation risk) to provide you with the income you require in retirement.
Controlling risk through diversification
Spreading your money across a range of investments is one of the best ways to reduce risk. It can help protect against sudden falls in any particular market, sector, or individual investment. With a well-diversified portfolio of investments, returns from better performing investments can help offset those that fare badly. This can lead to smoother returns overall. Diversification does not mean you will make a profit. In a declining market you are likely to sustain losses. However, it can reduce the risk of experiencing a heavy loss of from being over-committed to a single investment or area.
This article is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investors should be aware that past performance is not a reliable indicator of future results and that the price of shares and other investments, and the income derived from them, may fall as well as rise and the amount realised may be less than the original sum invested. Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus. If you are unsure of the suitability of your investment please seek professional advice.