Understanding risk

In the world of investments, most of us would jump at the chance to grow our money substantially, safe in the knowledge that there was no chance of losing anything. Unfortunately those opportunities don't exist.

In a sense, every financial decision we make involves risk. Even if you keep your money in a safe, you're running the risk that if prices increase what you can buy with your money will be less.

Then there's the more familiar kind of risk: if you put money into the shares of a company which fails, the value of those shares could reduce to zero.

Getting an understanding of the different investment risks – and deciding how much risk you're comfortable with – is an important step to planning for a healthy financial future.

Five steps to understanding risk

Please read each of the five steps carefully

What is investment risk?

  • High risk funds have the potential to make a lot of money – but equally all the money invested could be lost.

What is volatility?

  • Volatility refers to how often, and how far, an investment's value rises and falls over time.
  • Investing in funds with high volatility could mean having very little money at a time when it's needed – but such funds often bring more opportunity for high returns. Lower risk investments tend not to change as much over time, but can offer lower returns.
  • Overseas investments involve an additional layer of uncertainty: exchange rates. If funds are withdrawn when the exchange rate is poor, the investor may not get as good a return on their investment.
volatility graph volatility graph

The effect of inflation on investments

  • Risk occurs when savings don't grow as quickly as prices increase, so the value of money becomes less over time.
  • No-one knows how quickly prices will increase in the future, the average annual inflation rate in the UK over the past 10 years has been around 2.7% (as measured by the Consumer Chart Index).
  • 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% 5.0%
10 years £110 £128 £163
20 years £122 £164 £265
30 years £135 £210 £432
40 years £149 £269 £704

Why time is important

  • For most people, it makes sense to 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 – paying school fees, perhaps, or 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

  • By investing in different types of assets at different levels of risk, poor performance in one could be balanced by good performance in another. Of course this depends on the type of assets invested in – each situation will differ.
  • Taking a high-risk approach to investing may lead to a high pay-off – but it might also lead to a loss, since riskier investments are more likely to come unstuck. A low-risk approach may be safer, but might not bring in as much reward. Investors may want to balance their investments in line with the overall level of risk they 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. This is because more of an asset is bought when its price is low and less when it's higher.

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.

Need some advice?

If you’d like a hand deciding where to invest your money, a financial adviser could help.

If you don’t have a financial adviser and would like more information about getting financial advice, visit our financial advice page.

Risk and return ratings

The next step to understanding our range of funds is to understand risk and return.

Risk and return savings

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