In the world of investments, risk is a constant companion. Not knowing what the future holds can be unnerving. But if you make smart decisions and invest in the right places, you can reduce risk, increase the reward, and create significant returns.
In this article, we've set out the common risks that affect portfolios, and four steps to overcome them.
What is investment risk?
Investment risk refers to the possibility of an investment falling in value. Investments that have a higher level of risk usually have a higher potential return. Low risk investments, on the other hand, might minimise your risk of losing money, but they may not provide significant opportunities for substantial gains.
Common types of investment risks
1. Market risk
Market risk is the risk of experiencing a decrease in market value due to economic developments or other events that affect the entire market, known as systematic risk. We've outlined the four main types of market risk below.
- Currency risk is the change in price of one currency relative to another. If you have assets or business operations overseas, you’re exposed to currency risk that may create unpredictable profits and losses.
- Equity risk is the potential for the value of your investment in stocks to fluctuate, leading to potential gains or losses. Risks include share price falls, receiving no dividends or receiving dividends lower in value than expected.
- Interest rate risk is the likelihood that the value of your investment will decline due to an unexpected change in interest rates. This risk is mostly associated with fixed-income investments, such as a bonds.
- Commodity risk is the uncertainty of future market values and the size of future income, caused by fluctuation in the prices of commodities. Uncontrollable factors, such as inflation and political unrest, can have a big impact on their price.
2. Inflation risk
Inflation risk is the risk that unexpected inflation will erode the real value of the returns delivered by your investments. For example, if you hold fixed-interest investments (like bonds) inflation can diminish the value of the interest payments, as well as their face value when they’re returned.
Putting money in banks and building societies offers you security, since you can always get your money back. However, it’s particularly vulnerable to the effects of inflation, especially in the current climate when inflation is at an all-time high.
3. Liquidity risk
Liquidity risk is the risk that you may not be able to sell your investments quickly or at a fair price. With liquidity comes the possibility that you may have to accept a price you don’t want. This risk applies mostly to investors who hold illiquid assets, meaning they cannot be easily sold for cash without losing value. They’re often difficult to sell quickly because of a lack of investors or buyers. Examples include property, classic cars, rare art, stocks, and bonds.
How to minimise investment risk
Consider the following strategies to shield your investments:
1. Diversify your investments
Investing in a variety of asset classes, industries, countries, and company sizes can spread out risk and reduce the chances of any single investment heavily impacting you. A diversified portfolio across cash, stocks, bonds, and property can help manage volatility.
2. Regularly rebalance your portfolio
It's useful to review your portfolio from time to time, to make sure it still matches your goals and investment outlook. For example, you may have initially put 60% of your portfolio in stocks and 40% in bonds, but due to market movements, your stocks have lost value. To ensure your investment portfolio aligns with your risk tolerance, consider revisiting your asset allocation each year.
3. Take a long-term investment approach
Investing requires patience and a focus on long-term goals. During periods of market volatility, it’s important to stay calm and avoid making impulsive decisions. Remember that despite temporary setbacks, investments have the potential to recover and grow over time.
Selling investments prematurely can result in missing out on future gains. For example, the FTSE 100 Index fell dramatically in 2020, as global share prices fell following the impact of COVID-19. However, since then, the FTSE has generally been on an upward trend and hit a series of record highs in February 2023.
4. Seek the expertise of a Financial Adviser
For help managing your portfolio's risk, a Financial Adviser's expertise can be valuable. They can help you build a diversified portfolio, rebalance your assets, and guide you in identifying where your investments may now exceed your risk tolerance.
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