The word ‘risk’ is often bandied around in the world of investing. It can be a pretty alarming term, especially when mentioned in the same breath as your hard-earned savings. Yet many investors seem to carry on quite happily regardless of the risk. Are they just crazy adrenaline junkies or do they know something we don’t?
Actually, they do. When people talk about investment risk, they sometimes forget the other part of the equation which is ‘reward’. It’s a very simple equation: there is no reward without risk. But let’s be clear here - more investment risk does not automatically mean you’ll achieve higher returns, rather you have greater potential for higher returns. You also, of course, carry a higher chance of losses when taking more investment risk.
How this plays out in real life is simple. Opening a savings account at the bank is hardly the investment equivalent of climbing Mount Everest. You could argue that there is very little investment risk involved with this decision; you are unlikely to lose capital in absolute terms. You’re unlikely to get back less than you invested. The outcome for your money is pretty certain and you will be rewarded accordingly - with an interest rate covering inflation if you’re lucky. (There are, of course, still risks with cash; you could lose value from your cash in real terms to inflation and you also have credit risk if the bank or savings institution fails*).
In contrast, buying stocks or funds is a step up the investment risk ladder. Stock markets are made up of a multitude of investment securities, each with its own price. These can swing around as the fortunes of the economic environment or the companies they represent change. There’s no guarantee that when you want to sell, the price will be higher or even the same as when you bought. This is the crux of ‘investment risk’ - you may get back less than you originally invested.
These swings in price are called known as volatility. Because those swings can be steep, volatility is often confused with investment risk but it’s not necessarily the same. A volatile share price doesn’t always mean the company is going to go bust. Likewise, it’s entirely possible that a firm with a plodding share price could collapse. However generally speaking, the more volatile investments are considered to carry a higher amount of investment risk than less volatile investments.
Volatility is great if you can sell when there’s an upward swing in value. However, it’s not so much fun if you want (or need) to sell in a downward spiralling market. But don’t worry, there are some simple steps you can take to manage volatility and investment risk.
1. Maintain an emergency fund
Keep sufficient money in cash to keep you afloat for several months should disaster strike. A minimum of 3-6 months of your income need is usually recommended. You don’t want to be forced to sell investments to raise cash when markets are moody. You can read more about this in our getting ready to invest post.
2. Get time on your side
Time allows your investments to ride through different economic cycles, smoothing out any short-term volatility. Over long periods of time, equities tend to outperform cash quite convincingly, but the same is not always true in the short-term. Time and volatility are good friends, but urgency and volatility, not so much. So keep your eye on the prize, investing is a marathon, not a sprint.
3. Automate top-ups
When is the optimum time to invest? There’s no easy answer to that because no-one, not even the professionals, can accurately predict stock market peaks and troughs. Save yourself the bother of guessing by investing a fixed sum regularly with regular payments. Automated top-ups mean you buy less assets when they are expensive and more when they are cheap - without lifting a finger.
Similarly, when stock markets are rocky, it might be better to drip-feed a lump sum into the markets rather than trying to identify the perfect moment to invest the whole lot. But each to their own!
A good way to balance risk and return is to diversify your investments. You could add some bond funds to your equity funds, for example, or mix up your UK funds with international ones.
Drilling down further, you could mix and match by style (growth/value/GARP etc - you can read more on those in some of our other Insights) or by combining passive and active funds. There are many different ways to achieve diversification, but the general benefit is that you’re not disproportionately impacted when one style/region/etc is out of favour.
Though it can be worrying to see your investment valuation turn red, it’s important to remember that this is not necessarily a signal to sell. Swings in asset values are entirely normal and generally stabilise given time. If you panic and sell out too early, you may miss the upswing when the recovery comes. In that scenario, the risk of crystallising your losses can become all too real. So sit back, relax, and stop checking your account every week. Now that wasn’t so hard, was it?
*Your UK deposits are, of course, protected by the Financial Services Compensation Scheme up to £85,000 per banking licence.
Date of publication: 16th July 2020
Date of revisions: 2nd February 2023
The information in this post is not financial advice, it is provided solely to help you make your own investment decisions. If you are unsure about whether an investment is appropriate for you, please seek professional financial advice. You can find more information here.
When you invest you should remember that the value of investments, and the income from them, can go down as well as up and that past performance is no guarantee of future return.