Understanding lower risk investments

Risk makes a lot of people nervous, especially when it comes to investing. After all, no one likes the idea of losing their money. But without taking some risk, growing your money can be difficult. If you have a cash savings account, you’ve probably experienced this for yourself.

So, if you're looking for a middle ground between the high risks of the stock markets and the lower growth of cash savings, you might consider lower risk investments.

Saving (depositing money in a cash account) and investing (buying assets that are hoped to grow in value or generate an income) can both have a role in a successful financial plan.

Recently interest rates have increased but it may be that the actual spending value of cash savings has not. This is because, despite interest rates rising, they have not kept pace with inflation. So while higher interest rates mean higher returns,  remember the impact inflation can have. Interest rates can change at any time. This also means when interest rates are low your savings will only grow as much as you add to them.

So, some people are choosing to invest in a portfolio of stocks and shares, bonds, and other assets, which are higher yielding and which offer higher growth potential than cash savings. But doing this also involves more risk because the value of your investments could also go down and you could get back less than was originally invested.

Investments go up and down in value over time, so it’s impossible to predict if they’ll be worth more or less than they are now at any point in the future. Investment risk is the term that describes this uncertainty.

One factor in investment risk is volatility. All investments go up and down in value over time. Higher risk investments may go up and down by large amounts, and are said to be more volatile. Lower risk investments tend to go up and down by smaller amounts, so are said to have lower volatility. 

In other words, you could make the most money if you invest in highly volatile investments, but you have to accept a higher risk of seeing large drops in value too.

Another factor in investment risk is liquidity, which refers to how easy or difficult it is to sell an investment. A more liquid investment is easier to sell and should allow you to convert your money back to cash quickly if you need to. If an investment is less liquid (for example, commercial property such as a shop), it won’t always be possible to sell the property and convert your money back to cash.

No investment is risk-free, but there’s a huge spectrum when it comes to how much risk is involved.

Equities (sometimes called stocks or shares) are some of the most well-known investments.

They’re considered higher risk investments because they can go up and down in value very quickly and frequently.

Fixed interest assets, which include UK government and corporate bonds, are an example of a lower risk investment. Government bonds are bonds issued by governments as a way to borrow money and similarly corporate bonds are bonds issued by companies as a way to borrow money. Government and corporate bonds pay an income to the holder of the bonds and then the full value of the bond is paid to the investor when the bond matures, or comes to the end of its lifetime.

When managing investment risk, the goal is not to reduce your level of risk as much as possible, because a risk-free investment will usually not generate much of a return. Instead, the goal is to maximise your returns without taking on more risk than you’re comfortable with.

For example, a lower risk fund might invest mostly in fixed interest assets but not avoid equities entirely. Excluding equities would reduce the level of risk, but would also limit how much the fund could grow, and how much money you could earn from investing in it.

To manage risk while investing in some higher risk investments, investors use diversification.

Investing all your money in a single equity and so the shares of one company would be an unusual and very high-risk approach.

Instead, investors split their money between a wide variety of company shares and therefore equities from different industries, countries and regions around the world.

For example, multi asset funds invest in equities and bonds to help spread the risk of the fund across different asset classes.

The length of time that you’re investing for is another important factor in managing risk.

It’s normal for the value of your investments to rise and fall over time, so the value of your portfolio might increase in some months and decrease in others. But over several years, the value hopefully goes up. So, if you’re investing for the long term, you shouldn’t be too concerned about short-term dips in value, as you may well have time to get your money back and hopefully more.

However, if you need your money back quickly, short-term fluctuations will be a concern. If the value of your investments drops and you don’t have time to wait before selling, you could lose money.

If you need access to your money in the next five years, investing may not be suitable for you.

Some of the reasons you might choose a lower risk approach are if:

• You’re new to investing
• You don’t like the idea of your investments changing dramatically in value

Otherwise, you might choose a different approach or decide not to invest at all.

To reduce your risk level, there are three important rules to remember:

1. Choose a large proportion of lower risk investments
2. Diversify your portfolio by investing across multiple companies, sectors, and regions
3. Be willing to invest for at least five years

An easy way to choose lower risk investments is to pick a ready-made fund that's lower risk. Our direct investing platform offers this as one of four ready-made growth funds. All four funds are fully diversified, and the lower risk fund is typically invested mostly in fixed interest/bonds and cash. Within an Aviva Pension, we also offer a Universal Retirement Fund. It switches your investments to typically less risky ones as you get closer to retirement. To find out more, see what we offer through our direct investing platform.