Investment risk can be defined as the probability of loss or lower-than expected returns from an investment.

It must be understood that a risk-free investment does not exist, but investment funds vary between being low risk and high risk. Even cash held with a financially secure bank is exposed to inflation risk (the risk that rising prices will erode the ‘real’ value or purchasing power of the cash held on deposit) and counterparty risk (the risk that the bank is unable to meet its financial obligations, i.e. return a depositor’s money).

A commonly used measure of risk in the investment world (although it is by no means an exact science) is to look at the past annualised volatility of an investment. Volatility is a measure of how widely an investment’s range of returns have varied from its own (or its benchmarks) average return over a particular period of time; thus a higher volatility means an investment’s value can potentially be spread out over a larger range of values. For example, if an investment had an average annual return of 5% over the past 5 years and its volatility was 15, the range of annual returns over the 5 year period was between +20% and -10%.

Analysing an investment's risk and reward

The Risk/Return Tradeoff

The theory of risk and reward (or risk and return) is simply that for every unit of risk a person takes-on with their investments, they should be rewarded with the potential to achieve higher returns.

You can think about taking on more risk as payment for increasing the potential to achieve higher future returns. This theory does not always play out in the real world (i.e. an investment can be very risky but there is limited potential to achieve high future returns, and vice versa), but it is a good rule of thumb to have when making an investment.

A basic example would be the decision of whether a person keeps their money in cash or invests into the shares of a single small company. The cash is a relatively low risk option and it will achieve relatively low returns, whereas the share in the small company is a high risk option but it has the potential to make very large returns (but also could lose it’s value completely).

There are however ways to balance the risk return trade-off in your favour using tools such as diversification and investing over a longer period of time (see constructing your portfolio).

You should always remember that the value of your investments and any income from them can go down as well as up and you may get back less than the amount you originally invested. All investment carry an element of risk which may vary significantly.

  1. Cash Risk: Where a fund holds at any one time a substantial proportion of their assets in cash, near cash or money market instruments, it might not participate fully in a rise in market values of the asset classes the fund would otherwise invest in. As explained at the top of this page,  cash is also likely to be exposed to inflation risk.
  2. Concentration Risk: The risk of a portfolio or fund being too concentrated in particular positions or too exposed to certain issuers. This can exacerbate market, liquidity and counterparty risk.
  3. Counterparty Risk: The risk that the failure of a Counterparty to meet its obligations leads to a financial loss to a fund. In the event of either the issuing institution or Counterparty being unable to meet its financial obligations the investor may get back less than invested and at worst lose all of the capital invested.
  4. Currency Risk: The risk that assets held in another currency are negatively affected by the exposure to exchange rate movements. Changes in the exchange rate will affect the sterling value of your investment.
  5. Emerging Markets Risk: Emerging Markets are generally less well regulated than their established counterparts. Funds investing in these markets can be susceptible to significant fluctuations in price. They may also present a currency risk (see above). They can carry additional risk in other areas including dealing, liquidity and taxation. As such, these funds are aimed at the more experienced or higher risk investors, but may form part of a diverse portfolio.
  6. Liquidity Risk: This includes both market liquidity risk and funding risk. Market liquidity risk is the inability to trade an instrument at the desired price due to a lack of supply or market demand. Funding risk is where a fund has insufficient cash to meet its financial obligations.
  7. Inflation Risk: The risk that rising prices will erode the ‘real’ value or purchasing power of cash or an investment. For example, assets held in cash and some bond funds offer limited capital growth potential and an income not linked to inflation, thus inflation can affect both the value and income over time.
  8. Interest Rate Risk: The possibility that a fixed interest security (e.g. bond or preference share) will fall in value as a result of interest rate rises.
  9. Property Risk: It may be difficult or impossible to realise an investment in the fund because the underlying property concerned may not be readily saleable. The value of property is a matter of a valuer’s opinion and the true value may not be recognised until the property is sold.
  10. Short Selling and Leverage Risk: Funds may have exposure which involves short sales of securities and leverage, increasing the risk of the fund. Short selling is designed to make a profit from falling prices or hedging a long position. However, if the value of the underlying investment increases, the short position will negatively affect the fund’s value. Leverage (aka debt or borrowing) amplifies the effect of changes in the price of an investment on the fund’s value. As such, leverage can enhance returns to shareholders but can also increase losses.
  11. Systematic Risk: Also referred to as market risk, it is the risk that an event will affect all securities in the same manner, and therefore cannot be eliminated by diversification.
  12. Unsystematic Risk: Also referred to as business risk, it is the risk associated with a single issuer of a security. Specifically, it is the possibility that an issuer may fail entirely or be unable to pay the interest or principal in the case of bonds. This risk can be mitigated through the use of diversification.

Before you make an investment in a fund it is important to understand the specific risks associated with it. You should look at a fund’s Key Investor Information Document (KIID) which will give you a list of the main risks it is exposed to. The KIID is available for download within the platform or you can go to the fund providers website. As well as this, if you are unsure as to what certain investment terms mean or need help with some of the terminology we have a dedicated page here.

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