How do I Know How Risky an Investment is?
Good question. Finding a balance between risk and reward can be complex, but it’s also crucial
There’s always the possibility that you’re going to lose money when investing, or that you don’t make as much money on an investment than you had originally hoped. Say hello to risk, which is one of the key investment principles going and which you need to grapple with in order to navigate the stock market.
But there’s two sides to every story. By taking on too much risk, you run the risk of experiencing big drops in your portfolio. By taking not enough risk, your investments may not grow quick enough to meet your financial goals. So how do you find a balance between risk and reward?
The risk-reward concept
Risk and reward go hand-in-hand in investing, which is why there’s a trade-off surrounding any investment. That’s because there is always the risk that you may lose money, or not make as much money as expected. That’s because the market behaves in unpredictable ways – in other words, it’s volatile. The logic follows that the higher the risk, the higher the reward. On the other hand, the lower the risk, the less you can expect to receive in cash. But this is just a general framework for approaching investments, and doesn’t always pan out this way! Nonetheless, investors use the risk-reward ratio to determine the viability or worthiness of a given investment.
Asset classes and risk
So let's break down your investment portfolio and what it really means. Here are some of the main asset classes and investments and the risks they pose…
- Cash: Whilst it’s very low risk, it’s currently likely to deliver low returns and your money can be eroded by inflation. Find out more about inflation here.
- Bonds: Bonds are the next step up from cash. They are relatively low risk. Starting with government bonds or gilts on the lower scale of risk. Then corporate bonds which are slightly higher risk, as they are effectively loans to large companies, in exchange for a fixed rate of interest. Keep an eye out for ‘Junk Bonds’ as these are higher risk as they are companies that have a high risk of default (going bust)!
- Shares/stocks/equities: These are considered some of the riskiest assets as stock markets can be unpredictable. However, some markets are considered riskier than others. For example, investing in developed markets such as the UK and the US, are lower risk than emerging markets such as Brazil, China, and India. These markets are likely to be more reactive. For example, if something happens in the world, it could be an election, a tornado or a global pandemic, the stock market is likely to react and move around in value.
- Funds: These are generally regarded as an investment type offering high level of diversification and thereby mitigating risk. The amount of risk in the fund will depend on what the fund includes. You can find funds that only includes bonds (very low risk) or funds including stocks (more risky). If you choose a fund that follows an index (such as the S&P 500) you will get a great level of diversification in one investment.
- Property: Investing in commercial property such as warehouses and offices and is considered relatively low risk. However, it can be illiquid if funds struggle to sell the properties. This can make it hard to access your money.
- Cryptocurrencies: Bitcoin and other cryptocurrencies have been extremely volatile in the last few years. Seeing extreme rises and drops in a short space of time. It is also important to remember that there are many scams, and they are not covered by the Financial Services Compensation Scheme.
So now you know the risk level of different asset classes, the proportion of the asset classes within your portfolio will largely decide the level of risk you are taking.
What is the safest investment?
Government bonds are generally considered the safest investment. They are even dubbed ‘risk-free’. That’s because they guarantee that you return the principal amount invested, on top of the regular payments investors receive in the form of interest. Stocks, on the other hand, only pay out dividends when companies raise capital and you only make money on stocks if you sell them for higher than you bought them for.
Everyone has a different attitude towards risk. Take time to reflect on yours.
What is the riskiest investment?
There is no one answer to this question, as the level of risk associated with an investment can vary depending on a number of factors, such as the type of investment, the current market conditions, and an individual's personal tolerance for risk. Some investments, such as stocks or commodities, are generally considered to be riskier than others, such as certificates of deposit or government bonds. It is always important to carefully consider the potential risks and rewards of any investment before making a decision.
That being said, Cryptocurrencies, such as Bitcoin and Ethereum, can be a highly speculative and volatile investment. Their value can fluctuate significantly over short periods of time, and they are not backed by any government or central authority. This means that investing in cryptocurrencies carries a high degree of risk, and it is important to carefully consider the potential risks and rewards before making a decision. It is also important to thoroughly research any cryptocurrency and the platform on which it is traded before making an investment.
What is my risk appetite?
When investing, risk is unavoidable. Every investment poses some sort of risk, but some are higher risk than others. Generally, if we say something is high risk, what we mean is that it has a high chance it will fall sharply. This is also known as volatility. If an investment has a high level of volatility, it hits new highs and lows quickly, moves erratically, and has rapid increases and dramatic falls. This is important to remember when selecting an investment.
Everyone has a different attitude to risk. You may be filled with excitement when the value of your investment bounces around, you may think the opportunities are endless. Or this could be your worst nightmare. The thought of waking up and the value of your investment being 50% lower than the day before, fills you with dread. This is why it is important to understand your own attitude to risk and invest in line with this.
How do I determine my risk appetite?
So you’re new to the investing world, and there’s thousands of investments to choose from. The first step is figuring out your risk appetite, which invariably differs from person to person. So to figure out your risk appetite, ask yourself these two questions:
1. What’s my time horizon?
Figure out how much time you’re willing to spend invested in the stock market. You do this first by figuring out how much spare cash you have to invest, and when you need to take it out by. So say you have $25,000 but know you’ll be needing it for a house deposit in a year’s time, you’re going to want to put this in a low risk investments to ensure you don’t lose any money needed to make the down payment. On the other hand, if you don’t plan on putting a down payment down for another five years or more, you can afford to take on riskier investments. That’s because you have more time on your hands to bounce back from drops in the market, and you won’t be forced into a corner of having to sell off your investments early.
2. What are my goals?
First step is to consider your goals. If you you’re retiring soon, the logic follows that you’ll also be needing to withdraw your invested money soon. You wouldn’t want to risk having to sell your money off for less than you bought it for, so your safe bet is to stick with the low risk investments. Whereas if you don’t need the money for 5, 10, 15 or 20 years time, you have enough of a runway to recover from any temporary losses, giving you scope to delve into some riskier assets.
3. How much money do I have?
Because risk involves the potential of losing money, looking at how much money you’re actually willing to lose is key. Yes, we don’t go into investing expecting them to fail, but there is a possibility. So consider how much money you’re taking in every month. Because the reality is, if you have less spare cash lying around, you will feel more of a pressure to sell off assets when the chips go down – which could result in you selling them off for less you bought them for. So in a nutshell, the more money you have, the more risk you are able to take. If two people invest $20,000 in the same index fund, for example, the one with a salary of $2 million is going to be less impacted by the person who has a salary of $50,000. It’s just the way the cookie crumbles!
How does time affect risk?
The longer the time horizon, the lower the risk – it’s that simple. If you’re in the stock market for the long haul, risk is immediately less of an issue, than if you plan to dive into the stock market for any less than five years.
What does all this mean for me?
You are in the driving seat of your investments and where you put your money is down to personal preference. But by fully grasping the concept of risk, you’re already in a better position to make calculated investing decisions, rather than ill-informed ones. When it comes down to whether you should invest altogether, the answer should only be ‘yes’ if you are comfortable with some element of risk.
Finally, things to keep in mind…
- The greater return you want, the more risk you will likely have to take.
- The more risk you take, the higher the chance of losing some or all your investment.
- If you are short-term saving, we suggest taking a lower amount of risk to avoid large fluctuations in value.
- If you are long-term investing, you have more time to wait for markets to recover if there is a fall and your value drops.
- Most importantly…don’t panic! If there is a drop in the market, that is not a good time to withdraw your money. Wait for it to recover!