Understanding investment risk
What risk means for your money and how to manage it.
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. Most of us try to avoid risk when we can – like wearing a helmet to ride a bike or checking for traffic before crossing the road.
But when we talk about risk in the context of investing, it's not necessarily something you'll want to avoid. We’ll explain why.
What is investment risk?
In investing, risk refers to the possibility of an investment falling in value.
As a rule, investments which are regarded as riskier can have the potential to deliver a higher rate of return. You'll probably have a bumpy ride along the way, coping with the ups and downs of the market to try and get there - and there are no guarantees.
That might not be for you. Instead, you may want a smoother ride and be 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 riskier or prefer to play it cautiously, the approach you take is a very personal decision – and could change over time with your circumstances.
Whichever suits you, investing will always have some level of risk. Investments can be affected by anything from business performance or the economy to global events that rock the financial markets like the banking crisis of 2008, Covid-19 or the invasion of Ukraine in 2022.
The value of your investments can always go down as well as up, so you may get back less than you’ve put in.
Managing investment risk
Whenever you invest, you accept there's a risk your investments may fall. But there are some things you can do to manage that.
Focus on the longer term
As mentioned earlier, all investments go up and down over time. But generally, the longer you invest, the more chance there is of your investments being able to survive the ups and downs of the market. That's why investing is suggested for the long term (at least five years).
For example. if you're a pension saver under 45, you're in a great position to invest for the long term and may be prepared to accept more risk. With at least a decade until you can legally access your savings and around 20 years before you may retire, your investment should have enough time to withstand any market dips.
Avoid putting all your eggs in one basket
The saying goes, when you put all your eggs in one basket, you risk losing them all. The same goes for investing. With just one investment, you could make a big loss if it falls in value.
That’s why it’s recommended to spread your investments across different areas like stocks and shares, bonds and even property. It’s called ‘diversification’. So, if some of your investments are doing poorly, the losses could be balanced out by others 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 for you – using assets like stocks and shares, bonds or commercial property.
Funds can make it less likely to lose some of your money, as all the assets in a fund would need to perform badly at the same time. There have been occasions though when this has happened such as in 2022 when equities and bonds fell in value at the same time.
Some funds use smoothing. This is where the fund manager holds back returns earned during periods of good performance and uses them to reduce losses when things aren’t going 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.
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