What do we mean by risk?
Understanding the risks
There are different types and levels of risk that can affect your investments. Many people would assume that risk is a negative concept, but when it comes to investment, high-risk can also mean high reward. Risk alters over time, and can also change depending on the combination of investments in a portfolio. Understanding how to balance risk and reward is the key to achieving your objectives.
Risk is defined as the volatility associated with returns on investment, and is indicative of the potential for both losing and making money. So whilst the concept of risk may sound negative and you might associate it with loss, it can also mean that returns are unexpectedly high.
The nature of investing means that an investor can never know exactly what level of return they will make. This is what risk is, it is the fact that you don’t 100% know how much your money will be worth. Different investments carry different levels of risk.
When putting capital into a high-risk investment, like equity, you can expect to have a more volatile journey. However, a high-risk investment may also give stronger returns in the long term as risk diminishes over time.
This means that individuals who want to significantly increase the value of their investments are more likely to opt for high-risk investments, and as such will accept that their efforts could fail.
Meanwhile, low-risk investments, like bonds, have a lower return potential but are generally more steady. However, every investment comes with some sort of risk, and no single asset class can be depended upon to produce returns.
As well as the different levels of risk investors will encounter, there are also a number of different types of risk that it is important to know about when investing.
Inflation risk is relevant for those who leave a sum of money in a cash savings account. Whilst the amount of money they have won’t decrease, their buying power might if inflation rises. The Bank of England currently targets 2% inflation.
Market risk constitutes the rise or fall of the stock market in the country where an individual’s money is invested. If a benchmark index falls, the vast majority of shares will be dragged down with it.
Interest rate risk refers to when an individual puts their money in a fixed-rate deposit account. If savings rates rise, they could end up gaining less interest than the market average. However, if savings rates fall, they could be getting more beneficial rates.
Capital risk comes into play given the fact that the higher the investment returns an individual wishes to receive, the higher risks they must be willing to take. However, this also means you run the risk of your capital falling significantly.
Performance risk relates to the difference in performance between investment funds with similar objectives, due to the differing selection of assets by each one. Funds that have a high-performance objective will often encounter higher levels of volatility than those with a more traditional investment portfolio.
You should note that there are significant risks inherent in investing in certain financial instruments and in certain markets.
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