Understanding the risks

Investing your money in the stock market can be a good way to grow your wealth over time. However, before you commit any of your hard-earned savings it’s important to understand the risks involved.

This should be the first question you ask yourself before making any investment decisions. As all investments involve a degree of risk, you should really be thinking about investing for the medium to long term.

Investing over five years or more will help to smooth out the short-term ups and downs of financial markets. If you don’t feel comfortable committing your money for at least five years, investing in the financial markets may not be appropriate for you.

No reward without risk

It may be the case that in the long term your investment could provide a better return than savings. However, risk and reward go hand-in-hand. Before you make any investments you must be willing to accept a certain degree of risk. Different types of investments involve varying levels of risk. For example, it is generally accepted that sharesCloseSharesA share is a ‘unit of ownership’ in a company that is offered for sale to investors. It is also referred to as a ‘stock’. When you buy a share, you literally become a part owner of the company. You share in its financial fortunes, good or bad. People can buy and sell shares publicly on a ‘stock exchange’. Like any other market, the more people who want shares in a company, the higher the share price will tend to go. The fewer people who want shares in a company, the lower the share price will tend to go. Shareholders are also entitled to a share of the company’s profits, called dividends.sharesFind out more about shares by visiting our investments jargon busterInvestments jargon busterSharesA share is a ‘unit of ownership’ in a company that is offered for sale to investors. It is also referred to as a ‘stock’. When you buy a share, you literally become a part owner of the company. You share in its financial fortunes, good or bad. People can buy and sell shares publicly on a ‘stock exchange’. Like any other market, the more people who want shares in a company, the higher the share price will tend to go. The fewer people who want shares in a company, the lower the share price will tend to go. Shareholders are also entitled to a share of the company’s profits, called dividends. are riskier investments than bondsCloseBondsA bond is an IOU, typically from a government or a company. If you ‘buy’ a bond, you are essentially lending money to a government or company for a defined period of time, after which they promise to pay you back. In return, the company or government promises you regular interest payments at a fixed rate. Bonds are often referred to as ‘fixed interest’ investments. Lending to governments is usually less risky than lending to companies.bondsThis link will take you to the investments jargon buster page.Investments jargon busterBondsA bond is an IOU, typically from a government or a company. If you ‘buy’ a bond, you are essentially lending money to a government or company for a defined period of time, after which they promise to pay you back. In return, the company or government promises you regular interest payments at a fixed rate. Bonds are often referred to as ‘fixed interest’ investments. Lending to governments is usually less risky than lending to companies.Glossary. Always research thoroughly what you are about to invest your money in, or take advice from a qualified professional if you are unsure.

Here are three facts to keep in mind before you invest:

  • Financial markets are fickle friends. The value of your investments can go up, and make you wealthier, but they can also go down. There is always a chance you won’t get back what you originally invested.
  • When you’re researching stocks, it’s important to understand that the past performance of any investment is no guarantee of how it’ll perform in the future.
  • Tax laws can change and any tax advantages you might receive will depend on your individual circumstances.

You cannot eliminate risk completely, but you can manage it. Here are a couple of methods that people commonly use to manage their risk when they invest:

  • Don’t put all your eggs in one basket: The oldest risk avoidance strategy in the book. It is wise to invest your money across different markets, sectors and investment types. The hope here is that by spreading your investments, not all of them will fall at once. It’s also worth keeping in mind that it is unlikely they will all go up at the same time either. In industry jargon this strategy is called ‘diversification’.
  • Invest little and often: You could also try to invest smaller amounts regularly, rather than as a single lump sum. If you invest regularly over a longer period of time it can help to smooth out the ups and downs of the stock market.

Don’t forget, these methods only act to reduce risk, not to eliminate it. You could lose some, or all, of your money whatever the level of risk.

The best way to understand the risks of investing is to understand what you are investing in.

Asset classes

When people talk about ‘asset classes’ they are referring to the different types of investments you can make. For example: property, shares or bonds are all different classes of asset. Each of these asset types has its own level of risk and return. You can invest your money in various different types of asset, all of which will have a different level of risk and offer different levels of potential for growth.

Here are some of the major ‘asset classes’ and their relative risks and rewards:

Cash
  • How it works: Cash deposited at banks or building societies will earn you interest. Barring a complete financial collapse, it is highly unlikely you will lose your money if it is invested in a bank or building society.
  • Risk and reward: Cash is considered the least risky asset. However, keeping all your money as cash does have its downside. And that downside is inflation. Inflation is a sustained increase in the general price level of goods and services. If the rate of inflation goes up by more than the interest you are being paid on your cash in the bank, then that cash will buy you less.
Bonds and gilts
  • How they work: A bond is an IOU, typically from a government or a company. If you ‘buy’ a bond, you are essentially lending money to a government or company for a defined period of time, after which they promise to pay you back. In return, the company or government promises you regular interest payments at a fixed rate. For this reason, bonds are often referred to as ‘fixed interest’ securities.  UK Government bonds are called gilts.
  • Risk and reward: The level of risk depends on the financial dependability of the government or company issuing the bond. Bonds and gilts are generally classed as lower risk, compared to shares, and can also provide regular income.
Property
  • How it works: Property comprises residential property, like houses, and commercial property, like office blocks. You can invest in these assets directly or indirectly. If you invest indirectly in property this might be through buying shares in a company or investment fund that buys houses and offices and rents them out. A direct investment in property is when you buy the physical property itself. There are two ways to grow your money by owning property: first by the value of the property itself going up and, second, by charging rent to your tenants.
  • Risk and reward: The risk and potential returns in property can be higher than in bonds or cash. However, the limited market and time needed to buy and sell properties can mean that it’s much harder to get your money back if you want to cash in.
Shares
  • How they work: A share is a ‘unit of ownership’ in a company that is offered for sale to investors. It is also referred to as a ‘stock’ or ‘equity’. When you buy a share, you literally become a part owner of the company. You share in its financial fortunes, good or bad. People can buy and sell shares publicly on a ‘stock exchange’. Like any other market, the more people who want shares in a company, the higher the share price will tend to go. The fewer people who want shares in a company, the lower the share price will tend to go. Shareholders are also entitled to a share of the company’s profits, called dividends.
  • Risk and reward: Shares carry a greater risk than other asset classes, like bonds, and their value can be affected by the financial stability of the company as well as economic circumstances in general. However, they do have the potential for greater returns.
Commodities
  • What are they? Commodities are physical goods, like gold, oil and crops.
  • Risk and reward: The prices of commodities can rise and fall widely due to unpredictable events, including natural disasters and political unrest, so they carry a greater risk than shares. However, their prices can move in different directions to other assets, so holding commodities alongside shares and bonds can help to balance your portfolio.

Over the longer term, investments could offer better returns than cash savings, but in trying to achieve higher returns this does mean more risk.  When deciding how to invest your money, it's vital to understand the risk levels involved in different investments, and work out how much risk you're comfortable with. It's also important to consider how long you want to hold your investment; it's a good idea to invest for at least the medium to long-term (at least 5 to 10 years).

Your attitude to risk

When you’re considering investing, you'll need to think about both your attitude to risk and your ability to absorb losses.  Some people would be very unsettled by the prospect of the value of their investments falling, while others would be happy to accept the risk of ups and downs in the stock market.

There are a number of factors that will affect your capacity to accept the risk of losses, including how long you intend to invest for, your age and health, your income level, your investment goals, the source of your funds, and how much of your total assets the investment represents. All of these will have an impact on the level of risk you should take when investing. For example, if your investment is funded by an unexpected windfall, you may be more willing to accept a higher level of risk than if you were using your life savings.

When it comes to making the most of your savings, ideally you’d want to beat inflation by achieving higher returns than you might get from a normal deposit account.  We appreciate that you want to do this at a level of risk you are comfortable with.

Generally, the more risk you’re prepared to take, the greater the potential rewards. But everyone has a different attitude to risk, so here’s an overview of the main types of risk which you need to consider:

Interest Rate risk

If you save your money in a fixed rate deposit account for a fixed term you could find yourself getting a lower rate of interest than the market average if savings rates rise. However, if rates were to fall, your fixed rate could become more beneficial compared to other rates available.

Inflation risk

You are probably aware of the effect inflation has on your money. If you leave your money in an account receiving 2% interest per year and inflation is running at 3% per year, then although your capital (original investment) will have increased in value, its buying power has reduced by 1%.

Capital risk

A general rule of investing is that the higher the investment returns you want to achieve, the higher the risk you must be willing to take. That is because where high gains are achievable, there tends to also be higher volatility, which means that while your capital could grow significantly, it could also fall significantly.

You need to strike an appropriate balance between the risk to your capital that you are willing and able to take and the level of returns that you are looking for to reach your investment goals.

Market risk

This is the risk of a fall in the particular country's stock market where your money is invested. When a benchmark index, such as the FTSE 100, falls you will usually find that most shares are dragged down with it. Some fall by more than the average, some by less, but few will buck the overall trend.

You can consider investing gradually, for example on a monthly basis, as this may help smooth out big variations in the prices you pay. Similarly, if you are investing with a time horizon of at least five years then there may be opportunity to recover from any market losses. It is important to remember that you may not get back the original amount you invested if investment markets fall.

Performance risk

There will always be a variation in performance between funds with similar objectives due to the different assets selected by each fund. Funds aiming for relatively high performance can result in greater performance variations than those adopting a more conventional investment approach. The performance of your investment is not guaranteed.