A crucial component of any investment strategy
The question of how much investment risk one should take on has a variety of answers. It’s contingent on your unique circumstances, objectives, and comfort zone when it comes to risk. Some individuals are more at ease with risk, while others may be willing to take on more risk to reach their goals. Everyone has varying degrees of tolerance for different types of risk.
A crucial step in the investment decision-making process is understanding investment risk and determining your comfort level before investing. The potential returns from various types of investments and associated risks fluctuate over time due to economic, political, and regulatory changes, among other factors.
Assessing risk tolerance
There are several ways to gauge your risk tolerance. One approach is to contemplate how you would react if your investments lost value in the short term. If the prospect of a dwindling account balance causes anxiety, you might be risk-averse.
Conversely, you might be more open to taking risks if you’re okay with short-term losses for potentially higher long-term gains. Another way to evaluate risk tolerance is to consider your comfort level with market volatility, which refers to the rate at which prices of investments increase or decrease.
Investments with high volatility will see more significant price swings, while those with low volatility will see more gradual, steady price changes. Some investors are drawn to the prospect of significant gains from volatile investments, while others prefer investments that offer stability and slower growth.
Knowing your risk tolerance can guide you to make smarter investment decisions and help you avoid taking too much or too little risk for your objectives. Your investment goals and timelines will also influence your risk tolerance. The result of this process is your ‘risk profile’.
It’s natural to be wary of financial risks, but the truth is, there’s no such thing as a ‘no-risk’ investment. Every investment carries some degree of risk. For instance, funds holding bonds are typically less risky than those with shares, but there are always exceptions.
Understanding real-value risks
Money stashed in secure deposits like savings accounts runs the risk of losing value in real terms (purchasing power) over time. The paid interest rate may only sometimes keep pace with inflation. Conversely, index-linked investments that match the inflation rate only sometimes track market interest rates. This means if inflation dips, you could earn less interest than anticipated.
Inflation and interest rates
Investments in the stock market might outpace inflation and interest rates over time, but you run the risk of low prices when you need to sell. This could lead to a poor return or even a loss if prices are lower than when you bought. While risk can’t be avoided entirely, it can be managed by diversifying investments over the long term and making regular contributions rather than a lump sum. This can help balance the highs and lows and reduce the risk of substantial losses.
Different kinds of risks
Capital risk is when your investments can decrease in value, and you may not recoup what you invested. Investments in the stock market, whether directly or via a fund, will see daily fluctuations in value. You could lose some or all of your money depending on the company or companies you have invested in. Other assets like property and bonds can also lose value.
Inflation risk is when the purchasing power of your savings declines. Even if your investment increases in value, if the things you want to buy with the money have increased in price faster than your investment, you may not be making ‘real’ money. Cash deposits with low returns may expose you to inflation risk.
Credit risk is the risk of not achieving a financial reward due to a borrower’s failure to repay a loan or meet a contractual obligation. Credit risk is closely tied to the potential return of an investment, most notably that the yields on bonds correlate strongly to their perceived credit risk.
Understanding liquidity, currency, and interest rate risks
Liquidity risk is not being able to access your money when needed. Liquidity can be a significant risk if you hold assets like property directly and in the bond market, where the pool of buyers and sellers can dry up.
Currency risk is the potential risk of loss from fluctuating foreign exchange rates when investments are exposed to foreign currency or in foreign-currency-traded investments.
Interest rate risk is when interest rate changes affect your savings and investment returns. Even with a fixed rate, the market interest rates may fall below or rise above the fixed rate, affecting your returns relative to rates available elsewhere. Interest rate risk is a particular risk for bondholders.