Risk is perhaps the one and only guaranteed outcome an investor can expect. Even the act of not investing and holding everything as cash has an associated risk - such as inflation.
Although you can never remove risk from the equation, you can certainly use it to guide your investing strategy and ensure you are properly set up to realize you goals.
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| Photo by Adel on Unsplash |
What is risk?
Investment risk and reward usually translates as the amount of confidence you can have in some idea being profitable. There is no such thing as being 100% safe but we can all set what we are comfortable with.
What counts as a risky investment?
The most common assets to hold are: Cash, Bonds and Stocks. These, along with many other investments can be thought of almost like a pyramid of investment risk.
Cash - low risk, low reward
Generally cash is regarded as safe in that a lot of things has to go wrong in order for the US Dollar or the British Pound to literally become worthless. However you leave yourself open to inflation - even if you manage to get a good rate of interest from a bank, gains can be negated by inflation.
For a 2% rate of inflation (many countries target value) you would have to secure a 2% interest rate just to break even. Following the financial crisis of 2008 and the subsequent 2020 pandemic, such interest rates have been hard to come by in countries such as the US and UK.
Bonds - higher risk, higher reward
A bond is a form of debt - compared to cash this is a higher risk, as the value of your bonds can go up and down over time.
Within the category of bonds there is a range of risk - the industry generally uses a credit rating system to gauge risk. Different systems exist, but you will typically use a letter system that goes from: AAA, AA, A, BBB, BB...where AAA is the safest.
Although bonds are most risky than cash, some bonds (typically government bonds of secure countries such as the US) are considered so safe they are often referred to as "cash equivalent".
The risk here (and associated credit rating) comes down to the likelihood the borrower will default on the loan. A government bond with the US is generally regarded as very safe whereas a bond with a developing nation or less well established corporations are often deemed riskier, and potentially even called junk bonds.
Stocks - even higher risk, even higher reward
Over the long run stocks have proven to be the best of this three in terms of returns, however these long term gains are not consistent. Rather they tend to happen in cycles of booms and busts - this means that it is not just the asset you buy that affects risk, but also how long you intend to hold it for.
The standard reference point for how much money you are likely to expect from stocks is typically around 7% per year adjusted for inflation. This does assume that you hold your position for the long run as it is based on the long term returns of indexes such as the S&P 500 or FTSE 100.
Why take risk at all?
Risk itself can never really be removed so whatever move you make there is always something that can trip you up. To a certain extent even cash can be seen as a risk when you take into account inflation as a near guarantee in the long run.
But why do people take more risk on than they need to? This is often explained by the risk-reward curve.
The premise is that in order to receive higher reward you must be willing to take on greater risk. But rather than just picking one investment, many people would rather diversify by holding a number of different assets and using index funds.
This
article is not advice and has not been prepared in accordance with legal
requirements designed to promote the independence of investment research – no
recommendations are given in the buying, selling or holding of any investments.
Past performance is not a guide to the future. Investments rise and fall in
value so investors could make a loss.