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Risk

How to understand risk

Investment risk defined

With every financial decision involving some sort of risk, you need to be comfortable with the amount of risk you’re willing to take.

You could put money into the shares of a company which fails, meaning the value of those shares could reduce to zero. High risk funds have the potential to make a lot of money, but equally all the money invested could be lost.

Remember that the value of any investment can go down as well as up and you may get back less than you originally paid in.

The good news is that understanding what makes up risk could help you figure things out.

Let's take a look.


Volatility

Volatility is basically how often and how far an investment’s value rises and falls over time.

Investing in funds with high volatility often brings more opportunity for high returns, but also a greater potential for loss. And vice versa, lower risk investments don’t usually change as much in value over time – therefore having low volatility – so the potential for both growth and loss is more limited.

If you’re thinking about overseas investments, then they add an additional layer of uncertainty in terms of volatility: exchange rates. If money is withdrawn when the exchange rate is poor, you might not get as good a return on your investment. A lot of things come into play here, like the political environment of a country.


Inflation

No-one knows how quickly prices will increase in the future. Inflation risk comes about when your savings don’t grow as quickly as prices increase, so the value of money becomes less over time.

The table below shows what something that costs £100 now could cost in the future, depending on inflation.

What you'd need to buy goods that cost £100 after... Average annual rate of inflation
  1.0%
2.5%
10 years
£110
£128
20 years
£122
£164
30 years
£135
£210
40 years
£149
£269

Time

Most people keep part of their savings to hand, just in case – this might mean choosing an account that combines very low risk with instant access.

Investors with long-term goals, like paying school fees or, perhaps, retirement planning, might need a longer period of investment.

In the very short term, the risk of losing money from a more volatile investment could outweigh the inflation risk involved in holding a low-risk product. But as the length of time increases, this starts to reverse.


Reducing investment risk

Diversification

Diversification is investing in different types of investments at different levels of risk, where poor performance in one could be balanced by good performance in another. Of course, this depends on the type of asset you’d be invested in.

Taking a high-risk approach to investing may lead to a high pay-off, but it might also lead to a large loss, as riskier investments are more likely to come unstuck. A low-risk approach may be safer, but might not bring in as much reward. You might want to balance your investments in line with the overall level of risk you want to take.

Regular investments

Most investments will rise and fall in value over time, with the most volatile types showing larger and more pronounced swings than lower risk types.

Investing a regular amount over a period of time reduces the overall risk being taken, each payment will buy more assets when the price is low and fewer when the price is high, helping to balance out the gains and losses.

Risk-targeted funds

A risk-targeted fund invests with the aim of keeping to a certain level of volatility, which could be high or low.

The value of all our investments, even those in low risk funds, can go down as well as up. You could get back less than has been paid in.

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