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June 27, 2022

Do you understand investment risk?

We take another look into volatility and tell you more about what it means, how it is measured, and what steps you can take to understand it before, during, and after investing.

Understanding investment risk

We heard from Jill last time about her personal experience of volatility. And, at a time when you may be feeling unsettled by a setback in the value of your investments, we look at what investment risk means and why it is important to look beyond the day to day ‘noise’ in markets and focus on the longer term (by which we mean a minimum of 3-5 years). Our impact analyst, Liz, gives you a guide to investment risk. 

What is investment risk? 

We often associate risk with something negative, something that could cause harm, damage, or loss, but we don’t often take into account that there’s often a valid reason we take on risk. Things that come to mind might be:

  • the risk of crossing the road when the lights tell you not to (you risk injury or worse for maybe getting somewhere quicker); or,
  • betting on a horse (risk of losing your stake for potential winnings). 
  • telling someone a secret (risk of exposure for getting it off your chest).

We calculate risks daily, and, when it comes to investing it’s no different! There is a specific risk – the risk of losing money; and there is a potential reward – making your money grow. However, what’s slightly different to the examples above is that (like most things in finance) we have found a way to measure it. 

How can you measure risk?

Investment risk is usually measured in terms of volatility. Now you’ve heard that word from our last two articles. The first talked about the rough start to the year, and the second from Jill on her experiences of risk. So, now let’s look into what it actually means a little more.

Put simply, investment risk (that’s volatility) refers to how much a market, a fund, or an individual share has moved up or down, compared with its average value, over a given period of time. 

The rule of thumb is the higher the volatility the higher potential return or loss. So, if you hold a higher percentage of equities in your portfolio compared to bonds, you are more likely to have experienced greater ups and downs in 2022. We looked at the reasons behind the bumpy start to 2022 in this article.

How does a stock become volatile?

Let’s look at equities (shares in companies). The value of equities will react to the latest economic, political, company news etc., and investors around the world will trade on the basis of that information. This affects the price – if there are more sellers than buyers, the share price falls and vice-versa. 

Share prices can move in different directions, at different rates and at different times. A highly volatile stock would hit new highs and lows often which may make it look erratic, and it would have had rapid increases and dramatic falls. It can all get a bit complex, and we haven’t even got onto what happens with bonds yet… 

So, that’s why a fund can be a good idea. The fund manager takes this into account when aiming to meet their investment objective – they will choose the holdings and do the trading to try and keep the fund in line with what they are aiming to achieve for their investors. When you invest on The Big Exchange, you  are not trading but investing to take a buy-and-hold approach.

Why even invest?

In contrast, you could keep your savings in cash. Your initial capital stays the same and it’s only the invisible threat of inflation that can eat away at it. It is worth mentioning though, that investing may not be the best option for anyone who might need access to their money in the short-term. 

That said, whilst an individual company can become worthless, this is a rare event. What’s more, by spreading your money (and therefore risk) across a range of investments, as you do with a fund, the impact of any poor performers on your overall portfolio can be limited. 

How much risk do I need to take? 

Britain has a reputation for being a nation of savers rather than investors with cash ISAs accounting for 75% of total ISA subscriptions in the 2019/20 tax year.1   Recently, however, more of us have been turning to the stock market, no doubt hoping to improve on the returns offered on cash deposits. 

Once you decide to invest, it’s important to think about how much risk is right for you. There are two aspects to consider. The first is your personal attitude to risk, meaning how much risk you feel comfortable taking. Obviously, there’s no point being exposed to the stock market if it keeps you awake at night but do ask yourself if your concern is simply a fear of the unknown. 

The second is what is known as capacity for risk, which takes into account your time horizon and broader financial position. If your savings goals are a long way in the future, then you have plenty of time to ride out volatility. Also, the more money you have to invest, the greater scope you may have to include some higher risk products. 

As Jill mentioned, writing down a plan might help. Work out roughly how much you will need to meet your goals, the timescale to reach them, and whether you want to invest a lump sum or make monthly contributions. Regular investing can be a good way to smooth out market volatility. 

Reaping the potential rewards 

Over the long term, the up and downs in markets tend to be smoothed out and whilst past performance is no guarantee of future performance, the MSCI AC World Index (a popular benchmark for global shares) has returned 10.07% p.a. over the past 5 years. 2 

Meanwhile, cash savings rates have languished 4 and even the best 5-year fixed rate cash ISA (as of May 2022) still only offers an interest rate of around 2.2% p.a.5   Of course, if you keep your money in a cash account, whether at a variable or fixed rate of interest, it will be returned on request or at the end of the term (barring extreme circumstances).

Bonds sit between equities and cash in terms of risk; they pay a fixed interest coupon, but their value can rise or fall. However, as they tend to be less volatile than equities, they are usually considered a lower risk option. 

Diversify to reduce investment risk 

It’s worth remembering the old saying ‘don’t put all your eggs in one basket’ and ensure you have well-diversified portfolio. How much you hold in bonds, shares, property, and cash will depend on your attitude to, and capacity for, risk as outlined above (and our Bundles can help with that!) Not all the funds in your portfolio will perform well at the same time, but a balanced portfolio should limit downside better than trying to chase the winner. Timing the market may look easy with the benefit of hindsight but it really isn’t! 

Another way to diversify is by spreading your investments across different regions as each offers different opportunities. For example, the US tends to excel in technology, Europe is generally home to leading consumer brands, and some countries in Emerging Markets can benefit from favourable population trends. A simple solution may be therefore, to invest in a global fund which seeks out the best placed companies worldwide. 

We’re here to help

Investing in a fund, like those on the Big Exchange, delegates a lot of the decision making to professionals, taking away some of the day-to-day worries. 

There are funds to suit a range of risk appetites – you can check their KIID (Key Investor Information Document) on our website to find out where on the risk scale they sit. If this still sounds rather daunting, you might prefer to consider a multi-asset fund (you can filter for asset class on our full fund list) which caters for different risk appetites. 

Whichever approach you choose, don’t forget to monitor, and review your investments against your goals and how you feel. 

When investing, your capital is at risk. If you’re unsure whether an investment is right for you, please seek advice from an Independent Financial Adviser.

The value of your fund can go down as well as up. Tax treatment depends on an individual’s circumstances and may be subject to change. 

The Big Exchange (TBF) Limited is a wholly owned subsidiary of The Big Exchange Limited. The Big Exchange (TBF) Limited is an Appointed Representative of Resolution Compliance Limited, which is authorised and regulated by the Financial Conduct Authority (FRN 574048). 7120

 

Sources

1 https://www.gov.uk/government/statistics/annual-savings-statistics/commentary-for-annual-savings-statistics-june-2021

2 https://www.msci.com/documents/10199/f0e54c85-98b7-40eb-9a7b-bbb03288b523

4 https://swanlowpark.co.uk/savings-interest-annual

5 https://www.moneysavingexpert.com/savings/best-cash-isa/#fixed 

 All data accurate as at June 2022. Statistics and sources in this document will not be kept updated over time unless requested.

 

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