Investors need to ask themselves how comfortable they would be facing a short-term loss in order to have the opportunity to make long-term gains. The important thing to remember is that, even if an investment goes down, a loss will only actually be made if it is redeemed at that time. A fall in investment value is only a paper loss until the investment is sold. Investors need to be prepared to take some risk, and to see at least some fall in the value of their investment.
a) living with risk
Risk can never be eliminated, but it is possible to manage it, by spreading risk (diversification). Different investments behave in different ways and are subject to different risks. Putting money into a range of investments helps reduce the loss, should one of them fall.
It is also important to remember that risk and reward generally go hand-in-hand. The more risk taken, the higher the potential reward. Conversely, the lower the risk, the lower the return. As a general rule, it is not possible to achieve better than bank returns without taking a higher degree of risk.
b) types of investment risk
There are a number of types of Investment Risk. For example, there can be risk in the actual nature of the Financial Instrument itself.
Collective investment schemes can be very effective in reducing risk through diversification, it may contain other types risk specific to its very nature, including performance risk – related to the investment policies of the scheme, leverage risk – resulting from any borrowing withing the scheme, counterparty/ insolvency risk – the risk to the scheme of any counterparty defaulting on its obligations, currency risk – where underlying assets are in a different currency to the scheme, liquidity risk – the possible inability of the scheme to meet its short term payment obligations, operational risk – referring to the internal processes of the scheme & its management. In addition collective investment schemes need to be considered in respect of the underlying investment risks including: asset risk, currency risk, geographical/ political risk, inflation risk and liquidity risk. These risks are considered in more detail below.
Transferable Securities are subject to risk depending on their nature. These may include issuer risk – the danger of insolvency of the security issuer, market risk – volatility or price fluctuation, concentration risk – the risk of a lack of diversity in investment etc.
The following risks should be considered depending on the type and nature of an investment:
i) asset risk
This relates to different types of asset in the underlying investment and directly affects capital value.
Bonds are a loan to a company, government or local authority. Generally, interest is paid to the lender and the amount of the loan repaid at the end of the term. There are many other names for this type of investment, such as loan stock, fixed interest, debt securities, gilts (UK government)and corporate bonds. The main benefit of these investments is that the investor normally receives a regular stable income. They are not generally designed to provide capital growth. Bonds have a nominal value which is the sum that will be returned to investors when the bond matures at the end of its term. However, as bonds are traded on the bond market, the price paid for a bond may be more or less than the nominal value.
Bonds are generally less risky than having a Share in a company. One of the main risks is that the company can’t pay the interest or cannot repay the money at the end of the term. Bonds issued by governments will usually pay a lower rate of interest as a result of the preception that they are less risky.
Companies have different credit ratings and one with a high credit rating is regarded as safer than one with a lower rating. Companies with low credit ratings will have to offer a higher rate of interest on their bonds than companies with the top credit rating, simply to attract investors and to compensate for the higher risk.
Cash deposits are mainly for savings rather than investment, but they are still considered one of the main asset classes. Cash deposits — bank and building society accounts — are an excellent place for money needed in the short term (under five years) or as an emergency fund.
Cash deposits are generally considered to be safe — there are only usually problems if the bank or building society goes bankrupt. This is rare but it does happen,though many countries have in place compensation schemes to protect at least part of the holding. The downside, of course, is that the returns may not be particularly attractive over the long term. In addition, investors need to be mindful of the effects of inflation, relative to the amount of interest, as it may reduce the buying power of the original deposit (inflation risk).
Using cash deposits to save for the long-term, say for retirement, actually increases risk as the final return is likely to be lower than from a personal pension scheme with a broader range of asset types.
Commodities are physical substances such as food, grains & precious metals. They are used more and more in investment portfolios (for example, precious metals can provide a hedge against other assets such as currencies or stocks during times of economic uncertainty).
Commodities are subject to the laws of supply and demand and their value is affected by factors such as weather and the underlying economy (for example, in times of economic uncertainty in the US economy, the value of precious metals such as gold, tends to rise). As such commodities can be risky and volatile.
Derivatives (such as options, futures and held within hedge funds) are financial instruments, whose characteristics and value are dependent upon those of the asset from which they are derived (e.g., bonds, currencies, commodities & equities). They are used to manage risk and volatility and can also enhance performance.
Equities/ Shares are financial instruments signifying ownership in a company. They can be bought as part of a pooled investment or directly (on a stock-market through a broker).
Equities/ Shares: stock-markets go up or down as the price of the shares that are the constituents of that market go up or down. The main factor determining the price of a share is the perception of its current value. One factor that could affect the price of a share is a change in opinion as to how the company itself is performing or could perform in the future. Shares can be very volatile. However, risk and reward tend to go hand-in-hand, and in the long run, the aim is that these investments will provide better returns than other asset classes (but this is not guaranteed). Holding shares requires the investor to be comfortable with volatility, which can be very significant in the short term. However, by holding a wide range of shares (diversification), risk is reduced. Stocks are generally a long-term (minimum of 5 years) investment.
Property/Real Estate is mainly concerned with rental income and capital growth through a private buy-to-let purchase or commercial (company) arrangement. Those who invest directly in a buy-to-let will be tying up their capital and, unlike shares, bonds and cash, it can be difficult to get access to funds quickly as the property will need to be sold.
Property/Real Estate: as has been seen with the property boom and subsequent slump in the last decade or so, it is important to remember that property prices can — and do — go down as well as up. Investing in property directly carries various other risks, including the risk of interest rate rises if a loan is used; there is also the potential of problems with tenants and the risk of costly repairs and maintenance. Furthermore, it may not be possible to liquidate property quickly and property therefore contains liquidity risk.
ii) currency risk
Currencies (e.g. Sterling, Euro, Dollars, Yen) move in relation to one another. Investing in a currency other than the investors base currency will add another degree of risk (and potential return).
iii) geographical/political risk
Due to an increase in personal mobility and access to different markets, it is now possible to invest almost anywhere in the world through pooled investments. It stands to reason that some countries carry greater risk than others.
iv) inflation risk
This is the effect that inflation has on the value of investments. If inflation is 5% and investment return is 4%, capital is depreciating (its purchasing power is being eroded).
v) liquidity risk
This refers to the ease (or otherwise) of redeeming an investment. Property is an example of an asset that carries liquidity risk as it could take some time to sell a property. Other investments may impose a redemption restriction in order to reduce volatility. Investors should bear in mind liquidity (i.e. income requirements and access to capital) to ensure that the investment meets their needs.