to investment risks
This chapter provides a high level introduction to investment risks and investors’ risk profiles.
Speak to a financial adviser about a risk assessment to find out what level of risk you’re prepared to take on.
How much risk can you handle?
There are many different reasons for investing and no two people will have exactly the same objectives. For some it might be to pay off a mortgage, for others a way to build a retirement fund, or safeguard their long-term savings.
The level of risk that you, as an investor, may be willing to accept is an important consideration that needs to be established before making an investment. As well as your willingness (or not) to accept risk, you should also consider how much risk you need to take to reach your investment goals, and also how much risk you can handle without changing your life goals. The relationship between your investment objective, risk tolerance, and capacity for loss provides your overall attitude towards risk. This is often known as your risk profile. Your financial adviser can help you to ascertain your risk profile by means of a series of questions.
Typically, your risk profile will be identified by a number. The lower the number, the lower the amount of risk you are willing to accept.
Investment risk falls into the following broad categories; low risk, medium risk and high risk. Please see chapter 7, Building an investment portfolio, for further details on risk categories.
Different kinds of investment carry different levels of risk:
Cash or deposit accounts are often regarded as low risk, but they are not risk-free, as the crisis of the 2007 ‘credit-crunch’ showed. Inflation too can reduce the purchasing power of cash savings if it exceeds the rate of interest earned. This means that the real value of cash- based investments could decrease over time. There is also an ‘opportunity risk’ of not being invested into other types of investments that could potentially deliver better returns.
Many low-risk investors choose to invest in bonds or fixed-interest securities. When investing in a bond, an investor is essentially lending money to the issuer of a bond, usually a government or a company. In return for the loan, the issuer pays a rate of interest, usually at regular periods. The loan is usually repaid by the issuer at the maturity date. The benefit to the investor of this type of investment is that they expect to receive a regular income. However, there is a risk that the issuer may fail to return part or all of the original investment, or that the redemption or maturity value may be less than the original purchase cost, or that the issuer is not able to continue paying the regular income.
Historically, the best returns for a long-term investor have been from investment in shares (also referred to as ‘equities’). However, past performance is not a guide to the future and investing in individual shares does typically mean taking on a greater level of risk.
The price of a company’s shares trading on a stock market is a reflection of their value as influenced by the demand (or not) by investors. When you invest in a company, you are essentially buying a part of that company and its future profits. On the other hand, you also suffer any losses. The risks can be high, especially if you own shares in only a handful of companies. If one company is not performing well, this can have a significant effect on the overall value of your investment portfolio.
The exposure to the potential risk of loss in holding shares can be reduced by spreading the risk amongst several company shares in different sectors. This can be taken a step further by investing across a wide range of different ‘asset classes’, such as shares, bonds, and cash. This provides diversification across an investment portfolio, potentially reducing its overall vulnerability.
Investing in the stock market may be more suitable if you are willing to accept medium or high-risk investments. An adviser will be able to determine how suitable they are for you.
A way of investing in all these asset classes could be to invest in an investment fund. An investment fund offers a potentially less risky solution than holding a small number of shares directly. Under the supervision of a fund manager, an investment fund pools together money from many investors. This combined pool of money is invested by the fund manager across a number of assets with the aim of reducing the risk of the overall portfolio.
The concept is to enable investors to have a diversified portfolio with a stake in a wide range of assets.
Each fund has an objective which describes what it aims to accomplish for its investors and how it plans to achieve it. Some fund managers will aim to achieve high returns by investing in riskier shares, which offer potentially higher returns but could also result in higher losses. Others are more defensive, seeking reasonable gains without the threat of big losses. However, no matter where they invest, the value of investment funds may go down as well as up.
The choice of available funds is enormous. There are funds that invest in different countries, regions and industries – as well as a mixture of bonds, shares or other financial investments. A financial adviser will provide an investor with the necessary guidance when selecting funds for investment.
Achieving a diversified portfolio
Diversification isn’t just about investing in different companies. Other factors play a part.
Think, for example, about a portfolio holding shares in an ice cream company. If you buy shares in another ice cream company, your portfolio is less reliant on the performance of just one such company. However, it is still dependent upon a single factor: the demand for ice cream. If this demand drops, your portfolio will suffer.
By adding shares in another sector, for example a sun lotion company, you will have a more diverse portfolio and reduce the risk of being in one market sector. However, this would still mean over-exposure to a single risk: a rainy summer.
To help solve this problem, an umbrella manufacturer could be added to the portfolio – an asset that should appreciate during a rainy summer and go some way towards offsetting the poor performance of the ice cream and sun lotion companies.
Whatever the type of investment you are considering, it is important that it matches the level of risk you are comfortable with.
This is why Quilter International considers it essential that investors use the expertise of a financial adviser, who will be able to help you assess risk profiles and recommend suitable investments for you.