Understanding investment risk

The Cambridge Dictionary describes risk as "the possibility of something bad happening" . It's a definition that we're familiar with in day-to-day life. Indeed, most of us try to avoid risk when we can – things like wearing a helmet to ride a bike, checking for traffic before crossing the road, or, on a smaller scale, paying our bills in advance so we don't get a fine. 

But when we talk about risk in the context of investing, it's not necessarily something you'll want to avoid. 

Intriguing, right? Allow us to explain. 

What is investment risk?

In investing, risk refers to the possibility of an investment falling in value.

As a rule, investments that have a higher level of risk usually have the potential to deliver a higher rate of return. But you'll probably have a bumpy ride along the way, riding the ups and downs of the market to get that higher return and there are no guarantees.. 

Depending on your circumstances, you might be prepared to put up with a few bumps. Or you might decide that you want a smoother ride and you're happy with a lower, but steadier, return. In that case, an investment with a lower level of risk might be more suitable for you. 

Whether you decide to be a risk taker or prefer to play it safe, the approach you take is a very personal decision – and could change over time with your circumstances. 

And we have to say it: whatever approach you choose, there will always be some level of risk. Investing by its very nature is risky, and the value of your investments can always go down as well as up, meaning that you could get back less than you put in. 

Managing investment risk

Whenever you invest, you accept there's a risk your investments may fall. But is there a way to minimise that risk? Here are some things you can do to try. 

Take your time 

All investments go up and down over time. But generally, the longer you invest, the more chance your investments have to ride the ups and downs of the market — and the best chance you'll have of making a return on your money. That's why investing for the long term (at least five years) is a good idea. 

If you're a pension saver under 45, for example, you're in a great position to invest for the long term and accept more risk. With at least a decade until you can legally access your savings and, more realistically, nearer to 20 years before you will, your investment should have enough time to withstand any market dips.

Don't keep all your eggs in one basket 

If you keep all your eggs in one basket, there's a risk that you'll lose them all if that basket drops. It's the same with your investments. Make sure you're investing your money in lots of different things, like shares, property and bonds, for example. Diversification is the technical term. With diversification, if some of your investments are doing badly, potential losses may be balanced out by other assets performing well. 

One way to diversify is by pooling your money together with other investors in a fund. Here, a fund manager will decide what to invest in on your behalf and could invest in hundreds of assets within one fund. So it's less likely that you'll lose all your money, as all your assets would need to perform badly at the same time for that to happen.

Depending on the type of fund, hedging may also be used to minimise investment risk. Hedging simply means that the fund manager takes insurance against the value of their investments falling, or against the possibility of missing out on a rise in the value of an investment. 

Or smoothing may be used, where the fund manager holds back some of the returns earned during periods of good performance and uses them to reduce losses when things aren't going so well. 

Spread your investments over time 

Investing small amounts on a regular basis, rather than a lump sum up front, could help to spread your risk. This is known as pound-cost averaging. Buying shares in small amounts over a period of time means sometimes they will be expensive, and sometimes cheaper – so you get an average cost over time.