Please talk to your financial adviser about risk and its implications on your finances.
You can't plan financially without understanding investment risk. Many people, when they hear about 'risk', think automatically about the chance of being defrauded or not getting all their money back. This 'capital' risk is important, but it isn't the only type.
Other types of risk involve uncertainty and unpredictability. When you make an investment, it can be difficult to say with any certainty what you'll get back when you finally cash it in.
Share prices fluctuate, interest rates vary and inflation is a risk too. Just concentrating on capital risk and ignoring these other risks can mean you take too cautious an approach.
Understanding investment risk means identifying your own attitude to risk and identifying the different types of risk. When you understand all the risks involved, it can help to minimize the chances of things going wrong.
Some simple rules about investment risk
- The greater return you want, the more risk you'll usually have to accept
- The higher return you want from your investments, the greater the chance of losing some or all of your initial investment (your capital)
- If you're saving over the short-term it's wise not to take much capital risk. So what you are investing for and when you'll need access to your money will have a big impact on what types of investments are right for you
- If you are investing for the long-term you can afford to take more risk
- Investing in share-based assets has proved to be the best way for providing growth that outstrips inflation. There is a risk attached but, when you invest over the long-term, there is more time to recover your losses after a fall in the stock market.
Risks investors face
‘Investment risk’ is not a single number. Technically-speaking, ‘risk’ means the possibility of a number of different outcomes resulting from a given action. For example, before you flip the coin you know the result could be heads, tails or land on its edge. After you toss the coin, one of the three outcomes will occur. Investment academics usually identify risk as the volatility associated with the prices and/or returns of investments. However, we believe this approach is much too narrow for investors.
This is because investors do not think in narrow mathematical terms. Indeed, investors often think of risk as the prospect of an undesirable outcome, such as a financial loss or not meeting an investment objective.
Technically speaking, every investment carries at least some risk that you won't get back all the capital you invested. This is known as capital risk. However in practice some products are so safe that it's virtually certain you'll get what you were promised. For example, National Savings products and Government bonds (gilts) are backed by the Government.
Until recently we all thought we were pretty safe with our money sitting in a high street bank or building society, but that was before Northern Rock. However, despite the panic, Northern Rock investors were safe – even if the measures taken by the government to secure their safety were rather extreme and unusual.
The reality is that high street banks and building societies are forced to carry reserves and are monitored by the government. As a result, opening an account with a high street bank or building society is likely to be pretty safe for the foreseeable future.
And if the worst does happen (as it nearly did with Northern Rock), all authorised financial institutions in the UK are covered by the Financial Services Compensation Scheme so you would get at least some of your money back.
Inflation risk is the threat of rising prices eroding the buying power of your money. This risk is greatest if you invest in savings accounts.
Many savings accounts don't pay interest equal to the rate of inflation after tax, so even if you don't spend any of the interest, the 'real' value of your savings falls. If you spend the interest, the problem is even greater.
What do you think a shopping bag of goods and services costing £100 in 1981 would cost in 2011? The answer if £314.50. Inflation over those 30 years averaged 3.8%* a year which may not seem that high, however as you have just seen, the price of goods and services over that thirty year period rose by 214.5%
As you’ve just seen in this example, inflation is like a stealth tax eating away at the value of money. Some investors fail to see a smaller cash balance in their accounts, but they will definitely lose buying power. In other words, the amount that they can purchase with each pound in their pockets slowly erodes over time.
Investors need to understand that some savings vehicles fail to pay a return that beats inflation, especially after tax is deducted. So even if they reinvest every penny of interest, the real purchasing power of their savings could fall.
Shortfall risk means failing to reach your investment goal because the return on your investment is too low. For example, say you have a portfolio valued at £250,000 and your goal was to turn your £250,000 into £500,000 over a ten year period. To achieve your goal you'd need an annual return of 7.2% However if you failed to achieve your 7.2% annual target and achieved let’s say 3.6%, your £250,000 would have grown into £356,000, a £144,000 shortfall.
To reduce shortfall investment risk, you need to invest at least some of your money for a higher return but this may involve taking some capital risk.
In our next post we'll look at other investment risks that you might face, as well as how to understand your own attitude to risk.
You can read more at What is investment risk? (Part 2).
Please note past performance should not be used as a guide to future performance, which is not guaranteed. Investing in the Funds should be considered a long-term investment. The value of the investment can go down as well as up and there is no guarantee that you will get back the amount you originally invested.
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