What is risk?

Written by Jane Wallace · 16.07.20

Jane is a personal finance journalist who has written about investing for the last 25 years. In her spare time, she reviews books, writes bad novels and drinks a lot of coffee.

The word ‘risk’ is often bandied around in the world of investing. It’s a pretty alarming term, especially when mentioned in the same breath as your hard-earned savings. Yet other investors seem to carry on quite happily regardless. Are they just crazy adrenaline junkies or do they know something we don’t?

Actually, they do. When people talk about risk, they sometimes forget the other part of the investment equation which is ‘reward’. It’s a very simple equation: no reward without risk. But don’t confuse that with more risk equalling more return. Simply taking more risk doesn’t guarantee a higher return, just the potential of a higher return. However, you are unlikely to make much of a return if you don’t take any risk at all.

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. The outcome for your money is certain and you will be rewarded accordingly - with a measly interest rate, which only covers inflation if you are lucky.

In contrast, investing is a step up the 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.

These swings in price are called volatility. Because those swings can be steep, volatility is often confused with risk but it’s not necessarily the same. A volatile share price doesn’t always mean the company is going bust. Likewise, it’s entirely possible a firm with a plodding share price could collapse.

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 certain simple tricks for managing both risk and volatility and to try keep your money growing.

1. Maintain an emergency fund

Keep sufficient money in cash to keep you afloat for several months should disaster strike. 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 assets rather than trying to identify the perfect moment to invest the whole lot. But each to their own!

4. Diversify

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 - more on those in future posts) or by combining passive and active funds. There are many different ways to achieve diversification, but the general benefit is that you’re not totally off the guest list when one style/region/etc is out of favour.

Terrifying though it is 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 get 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?

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.

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