Understanding risk

Understanding risk

Broadly defined as exposure to danger, the word ‘risk’ often has negative connotations. A less emotive description would be that it simply means ‘the ability to measure or predict objective outcomes.’ For investors, risk is the chance that a particular outcome or financial gain differs from its expected outcome or return. Yet it is important to realise that risk is an inherent part of investing and shares a fundamental relationship with returns: the more risk an investor is prepared to take, the greater the level of potential returns. There are different types of financial risk that may prevent investors from reaching their financial goals. We have listed some of these below:
This refers to the risk to investments from movements in market prices such as stock prices, foreign exchange rates, interest rates and commodity prices. This could mean a loss in the value of your investments. The best known strategy for reducing market risk is creating a diversified portfolio consisting of multiple asset types that behave differently to each other in times of market stress.
Defined as the risk of being unable to sell your investments at a fair price and get your money out when you want to. To sell the investment, you may need to accept a lower price. You might also experience delays in selling the investment. And, in some cases, it may not be possible to sell the investment at all.
The risk that your investments will buy fewer things, so-called ‘purchasing power’ because the value of your investment fails to keep up with inflation. Inflation erodes the purchasing power of money over time – the same amount of money will buy fewer goods and services.
Credit risk applies to debt investments like bonds. It refers to the risk that a government or company that issues a bond might run into financial difficulties and won’t be able to pay their debt obligations. Credit risk is calculated based on the borrower’s overall ability to repay a loan.
Your portfolio can often be at a greater risk of loss if it is focused solely in the same sector, asset class or geographic location. This is because when an unexpected event occurs, in the short-term, markets often do not discriminate and all assets within an asset class or sector can suffer losses. You can offset this risk when you diversify your assets; you spread the risk over different types of assets, sectors and geographic locations. Or in other words, you avoid putting all your eggs in one basket.

Understanding Risk Podcast

AXA IM Select’s Lorna Denny sat down with Patrick Brenner from Schroders to discuss the concept of investment risk, the different categories of risk investors should be aware of, as well as how these risks can be mitigated in a diversified portfolio.

Concise and highly informative, it highlights some essential issues for consideration as well as providing investors with a helpful checklist.

The second in our Investment Basics podcast series, it’s ideal for those starting out on their investing journey but should also prove useful for more experienced market participants. Happy listening!

 

Choosing the appropriate level of risk

While there is a positive correlation between risk and return, a desired level of returns cannot be guaranteed. Risk exposure is therefore a trade-off to be viewed against the backdrop of an investor’s wider financial circumstances, and will depend on a range of factors, including their investment timeline/horizon and desired level of risk tolerance.

Taking on higher levels of risk to generate higher returns can potentially lead investors to lose wealth that they can’t afford. A broad rule-of-thumb suggests that investors should invest no more than 10% of their net assets (i.e. total investments excluding one’s primary home) in high risk investments which could be lost. Conversely, too little risk and an investor’s goals may not be achieved.

While all investors have their own specific resources and goals, one way of determining a risk-reward framework is to use an investment risk pyramid. Divided into three segments, the bulk of assets would be at the base layer and allocated to lower risk investments. As the pyramid narrows, so investment selection shrinks and becomes riskier.

Summit (high risk)

Occupying the top of the investment pyramid, holdings here represent the high risk/high reward options. While offering the possibility of outsized returns, their elevated risk profile – possibly comprising derivatives, commodities and cryptocurrencies - means that investors should be able to accept losses here with few repercussions to their longer term goals.

Middle (medium risk)

Including blue chip stocks, unit trusts, real estate and index trackers, this blend of slightly more risky assets offers the possibility of higher returns, while providing protection against weakness for a particular stock or asset.

Base (low risk)

Examples of financial assets in this category might include savings accounts and government bonds. These risk averse instruments provide capital preservation and an income stream.

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Starter Guide to investing

When you’re new to investing, getting started can seem like an uphill struggle. That’s why we decided to create a starter pack to help demystify the process and provide an introduction to the basics.

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