It is a basic fact of investing that risk and reward go hand-in-hand. The greater uncertainty, or risk, we are prepared to accept, the greater the potential for higher returns on our investment.
However, it is important to understand that no investment is risk-free. Only when you understand the different type of risks that apply to different types of investment can you answer the question, ‘How much risk am I prepared to take?’
Below are details of the main risks that apply to investments. With thousands of different investment opportunities available, the list cannot be exhaustive. You must ALWAYS thoroughly read and understand the literature that accompanies an investment. In it you’ll find details of the nature, the commitment required, and the risks and potential benefits of the investment.
If you buy any investment, be it a fund, an equity or bond, there is no guarantee that you will get all of your money back when you decide to sell. Generally, the lower the risk, the lower the potential return that you can expect. If your objective is to grow your investment in value then you will have no choice but to accept a certain degree of risk.
This is not a risk in itself, but a measure of how much the value of an investment goes up or down over a certain period of time. The more volatile an asset is, the more the price will change. The obvious risk is that you buy an investment while the price is high and sell it when the price is lower.
The credit crunch of 2008 showed how volatility can affect returns; many investors did not receive the value they were expecting as the price moved so quickly. Equally, more volatile investments can also have the potential to give the greatest return.
An investment that is designed to give a fixed return, such as a cash deposit, will have the least volatility whereas an equity, where the price is determined by market sentiment, will generally be more volatile. Equity values can change dramatically following individual events, and tend to be the most volatile. For example, a small mining company that suddenly strikes oil could experience a big jump in its share price – but if it only finds water, investors may sell their shares, causing the value to plummet.
It is important to recognise that past performance is not a reliable measure of volatility; an investment may have a steady price for some time and then suddenly increase or decrease in value. For example, a bond issued by a company may have a steady value until news emerges that the company might not be able to repay its debts, at which point the value of the bond will suddenly fall.
Even when you invest in a bond, structured product or even a cash deposit that appears to guarantee that you will not lose any money, there is a risk that you could, if the company that you are effectively lending money to is unable to repay its debts.
For example a bond may offer a ‘guaranteed’ return of capital invested but it may not be able to do so if the company that issued the bond goes bust. Some products invest money in a combination of bonds and derivatives so that, ordinarily, they will return all of the capital invested; but these could still leave your money at risk if the company that issues the bond or the derivative fails.
This is the risk that your money will not buy as much in the future as it does now, due to the effect of inflation on the price of the goods that you want to buy.
All investments are subject to inflation risk. And although keeping your money in a bank savings account, and to a lesser extent a fixed term deposit, may give you more certainty of return, ease of access and greater security, it increases your exposure to inflation risk because the returns may be lower than the rate of inflation.
To illustrate this with numbers, if inflation is 4% a year then your investment return needs to be greater than 4% otherwise you are reducing the purchasing power of your cash. If the return on your investment is only 3% then your money is losing 1% of its purchasing power in real terms – and over time, this can have a significant impact. The effect is compounded if you also have to pay tax on your investment.
Some investments require you to hold them for a fixed period of time, or give notice before you withdraw them. For example a 3 year fixed term deposit must be held for three years; a 90 day notice account requires 90 days notice before you can withdraw your money. In some cases it is possible to withdraw your money before the end of the term, or without notice, but there tends to be a financial penalty for doing so.
So fixed term risk comes in two parts: opportunity risk, where you may find that you could earn a higher return from another investment but cannot do so because your money is “locked up”; and the risk that a change in your circumstances could force you to withdraw your investment. This might not be possible, or could involve significant financial penalties.
In some circumstances, there may be no buyer available when you wish to sell your investment. This is a greater risk when you invest in smaller companies whose shares are not traded as much as those of larger companies and there is lower investor demand. It is also a risk with some bonds and structured products where there may not be a ready market.
Marketablity risk can result in there being a sizeable difference between the buying and selling price of an investment. It may also be more difficult to get accurate information about the value of the investment and there may be no recognised markets for funds if the units or shares are issued and redeemed solely by the manager or operator of the funds. The fund may not be available for purchase or sale every day, especially at times of exceptional market volatility, and trading in the fund might even be suspended if the manager does not believe that they can allow the redemption of units without disadvantaging the remaining holders.
This risk occurs when you have too much of your money concentrated in one area, for example all in one particular stock or all in one industry or sector which could all fall in value at the same time, as a result of a single event.
Currency exchange rates are constantly fluctuating and can change the value of your investments irrespective of its underlying value. If you invest in an asset that is priced in a currency that is different to your base currency, the volatility of the exchange rate will add to the volatility of the asset.
For example, if you buy a Dollar-priced fund using Sterling, the movements in the exchange rate will have an impact on the investment return. If the price of the fund has increased by 5% a rise in the value of Sterling against the Dollar will undermine this performance. Likewise, a fall in the value of Sterling, would amplify the performance.
In addition to these risks to investing, following the recent introduction of increased pension freedoms, the Financial Conduct Authority (FCA) is working to raise awareness of pension and investment scams. Be a ScamSmart investor; always exercise caution before investing.
Before you invest, make sure you feel comfortable with the level of risk you take. Investments aim to grow your money, but they might lose it too.