Understanding Investment Risk
It is no surprise that investment risk comes with its advantages and downfalls. Oftentimes, higher investment risk will come with higher returns but there is an increased chance you will lose your investment too. Risk can also mean different things to different people and how you think about it will typically depend on your personality, your personal circumstances as well as your investment goals. This is usually defined as your ‘risk profile’.
The reality is that understanding risk is a critical part of investing and planning for your financial future. If you understand the importance of managing risk between low and high-risk investments, and more importantly your personal preferences towards them, you will be able to make more informed decisions that will help you reach your investment goals.
Different Investment Types
There is no such thing as a no-risk investment but none of us like the idea of risking our savings. Generally speaking, the more risk you take, the more prepared you should be to enjoy good returns but also big losses.
When you invest, there will always be an element of risk and this will differ between the different types of investments you hold. For example, funds that hold bonds are usually less risky when compared to those that hold shares.
Money Loses Its Value Over Time
When you place money into a savings account, it can lose its value or its buying power over time. This is down to the way in which interest rates won’t always stay ahead of rising prices or inflation. In contrast, index-linked investments that track the rate of inflation won’t always follow market interest rates, so if inflation drops, you could see lower returns than you might have expected.
The Impact of Inflation and Interest Rates
Over time, stock market investments might perform better than inflation and interest rates although the prices might drop at a time when you need to sell. This will end in lower returns or you might lose money if prices are lower than when you purchased.
It’s not possible to completely avoid risk but it’s possible to manage risk by investing in different things over a longer period of time. This is known as diversification and you can make regular payments into your investments as opposed to doing it all at once. This can help you to ride out the highs and the lows and reduce your risk of losing money.
It is possible that your investments can also decrease in value which means you might not get your initial investment back. When you make investments in the stock market (equities), this is usually done directly through shares or through a fund. The stock market will fluctuate each day and this can be by varying amounts. This means you could lose all or some of your money while other assets can also drop in value such as property and bonds. On the contrary, you can also make money when your investments go up in value.
Over time, your savings will lose purchasing power. Even if you see your investment increase in value, you might not be making money in a real sense if the goods you want to buy with cash have increased in value at a quicker rate than your investment. Your exposure to inflation risk can increase if you deposit cash with low returns.
Credit risk is linked to not receiving your financial reward as a result of a borrower failing to repay a loan or a contractual obligation. This is closely linked to the possible return of an investment, with the most notable being the returns on bonds correlating with their perceived credit risk.
This relates to being unable to access your money when you need to. Liquidity is a possible risk if you have assets that include the likes of property as well as the bond market. In the ‘bond’ market, the pool of people who want to buy and sell bonds could decrease or disappear therefore impacting your ability to liquidate your bond investments.
It is possible to lose money as a result of currency exchange rates fluctuating over time. This is an important factor for international investors to consider, as they often hold investments in various currencies.
Interest Rate Risk
Your returns on savings and investments can be affected by changes to interest rates. Even if you opt for a fixed rate, the interest rates in the market could drop to a level that is either below or above the fixed-rate and this will have an impact on your returns relative to rates that can be found elsewhere. This is a risk for those who hold bonds.
Need Help Understanding Investment Risk?
At Pyrmont Wealth, our financial planners and investment team can help you understand investment risk and more importantly, help you create a bespoke LifePlan and investment plan that helps you make the most of your life and money. Contact us today to learn more: