Understanding Investment Risk: The Basics Every Investor Should Know

Investing always involves some degree of risk. The key is not to try to avoid risk altogether, but to understand what types of risk you are taking, why you are taking them, and whether those risks are appropriate for your circumstances and objectives.

For UK investors, this is particularly important when investing for long-term goals such as retirement, building wealth or generating an income. A financial adviser can help you understand the different forms of investment risk and build a portfolio designed around your attitude to risk, your financial position and your capacity to absorb losses.

What is investment risk?

Investment risk is the possibility that the value of an investment will fall, that it will not produce the return you expected, or that you may lose some or all of the money invested.

Different investments carry different levels and types of risk. Cash, bonds, shares, property and alternative investments can all behave differently depending on economic conditions, interest rates, inflation and investor sentiment.

An independent adviser can help explain these risks in the context of your wider financial plans rather than considering individual investments in isolation.

Risk and return are connected

In general, investments offering the potential for higher long-term returns tend to involve greater uncertainty and greater short-term fluctuations in value.

For example, shares have historically offered greater growth potential than cash over long periods, but they can also experience significant falls over shorter periods. Cash, meanwhile, may appear less volatile, but it comes with another important risk: inflation.

A financial advisor offering the best service should therefore consider much more than simply whether an investment has gone up or down in the past. The important question is whether the level of risk is appropriate for your objectives, time horizon and financial circumstances.

Book a meeting with an adviser to discuss how much investment risk may be appropriate for your financial plans.

The main types of investment risk

Market risk

Market risk is the possibility that investments fall in value because of movements in financial markets.

Share prices, bond prices and other investments can be affected by economic growth, interest rates, political events, company performance and investor confidence.

Short-term market falls are a normal part of investing. The difficulty comes when investors take more risk than they are comfortable with and sell during periods of volatility.

A financial adviser can help ensure your portfolio is structured around a level of market risk you are prepared to accept.

Inflation risk

Inflation reduces the spending power of money over time.

For example, if your savings grow by 2% a year but inflation is running at 3%, the real value of your money is falling.

This is one reason why holding all long-term savings in cash can itself involve risk. While cash can be useful for emergencies and short-term expenditure, investors may need some exposure to assets with greater growth potential if they want their wealth to keep pace with inflation.

A financial advisor looking at pension planning will often consider inflation particularly carefully because retirement may last for several decades.

Interest rate risk

Changes in interest rates can affect the value of many investments, particularly bonds.

When interest rates rise, the value of existing fixed-interest bonds will often fall because newly issued bonds may offer more attractive rates. The reverse can also happen when interest rates fall.

Interest rates can also influence share prices, property valuations and borrowing costs.

A certified adviser or suitably qualified financial adviser can explain how interest rate movements could affect different parts of an investment portfolio.

Credit risk

Credit risk is the possibility that a company or government issuing a bond is unable to make interest payments or repay the money it owes.

Higher-quality borrowers generally offer lower interest rates because the perceived risk of default is lower. Lower-quality borrowers may need to offer higher yields to attract investors.

This means a higher income from an investment does not necessarily mean it is a better investment.

When you find financial adviser support, it is important that investment recommendations consider not just potential returns but the credit quality and overall risk of the investments being used.

Liquidity risk

Liquidity risk refers to how easy it is to sell an investment and access your money.

Shares in large listed companies can normally be bought and sold relatively easily. Other investments, such as commercial property funds, private investments or certain specialist assets, may be much harder to sell quickly.

This can become particularly important if you need access to your money unexpectedly.

An independent adviser can help make sure an investment portfolio retains sufficient liquidity for your short- and medium-term financial needs.

Book a meeting with an adviser if you would like to review whether your current investments give you appropriate access to your money.

Concentration risk

Concentration risk arises when too much of your money is invested in a particular company, sector, country or type of investment.

For example, an investor holding a significant proportion of their wealth in shares from the company they work for could be exposed to both employment risk and investment risk from the same source.

Diversification can help reduce this risk by spreading investments across different assets, regions and sectors.

A financial advisor can provide a broader service by looking at your entire financial position, including investments, pension assets, cash reserves and other sources of wealth.

Currency risk

UK investors frequently hold overseas investments, particularly through globally diversified funds.

The value of those investments can be affected by movements in exchange rates.

For example, if a UK investor owns US shares and the pound strengthens against the dollar, the sterling value of those investments may fall even if the underlying shares have increased in value.

Currency movements can therefore either increase or reduce investment returns.

Behavioural risk

One of the most overlooked forms of investment risk comes from investor behaviour.

When markets fall sharply, investors can understandably become nervous. Some may sell after prices have already fallen and then wait too long before reinvesting.

Similarly, investors can become overly confident when markets have performed strongly and take more risk than they would normally accept.

A financial adviser can help provide discipline and perspective during periods of market volatility, rather than allowing short-term emotions to drive long-term financial decisions.

Attitude to risk and capacity for loss

Two investors can have exactly the same attitude towards investment risk but very different financial circumstances.

Attitude to risk relates to how comfortable you are with uncertainty and investment losses.

Capacity for loss, however, considers how much financial loss you could actually afford without materially affecting your standard of living or future plans.

Someone may be emotionally comfortable with significant investment volatility but unable to afford a major loss shortly before retirement.

A financial advisor reviewing protection, retirement planning and investments together can help make sure these risks are considered across your overall financial position.

Your investment timeframe matters

Time is one of the most important factors when considering risk.

An investor who needs their money within two years will generally have a very different risk profile from someone investing for 20 or 30 years.

Longer investment periods can provide more opportunity for markets to recover from short-term falls, although there is never any guarantee that investments will increase in value.

When recommending investments, a financial adviser should therefore consider when the money is likely to be needed as well as the investor’s willingness to accept risk.

Diversification does not remove risk

Diversification is one of the most important principles of investing, but it does not guarantee that a portfolio will never fall in value.

Instead, diversification aims to reduce reliance on any single investment, sector or market.

A diversified portfolio might contain a combination of UK and overseas shares, government and corporate bonds, cash and other investments.

A financial advisor can help assess whether the fees associated with different investment solutions represent reasonable value for the diversification and investment management being provided.

Risk can change over time

Your ability and willingness to take investment risk is unlikely to remain exactly the same throughout your life.

A younger investor building a pension may have several decades before they need to access their money and may therefore be comfortable taking more investment risk.

Someone approaching retirement may need to think more carefully about short-term market falls, particularly if they expect to begin withdrawing money from their investments.

Major changes such as retirement, receiving an inheritance, selling a business or changes to family circumstances may also affect the amount of risk that is appropriate.

This is why investment risk should be reviewed regularly rather than assessed only when an investment is first made.

Book a meeting with an adviser to review your investments, attitude to risk and long-term financial objectives.

The role of financial advice

Understanding investment risk is about more than completing a questionnaire and selecting a risk score.

A financial adviser should consider your objectives, financial position, investment experience, time horizon, capacity for loss, tax position and wider financial arrangements.

The top priority should be ensuring that the investment strategy is suitable for you rather than simply choosing the investment that has performed best recently.

A financial advisor can also help you understand the relationship between risk, potential return, investment fees and the likelihood of achieving your long-term financial goals.

Final thoughts

Investment risk cannot be completely removed, and attempting to avoid one type of risk can sometimes introduce another.

Keeping everything in cash may reduce short-term market volatility but increase inflation risk. Investing heavily in shares may improve long-term growth potential but expose you to larger short-term losses.

The aim should therefore be to take an appropriate amount of risk for your circumstances.

Working with an independent financial adviser can help you understand the risks you are taking, diversify your investments appropriately and keep your strategy aligned with your financial objectives as your circumstances change.

The value of investments can fall as well as rise and you may get back less than you invest. Past performance is not a reliable indicator of future results.