What is investment risk?

We all take risks in our daily lives. Driving a car, crossing a road, climbing a ladder, playing sport – virtually any activity can lead to damage or injury, though the likelihood of misfortune is generally low unless you are particularly reckless.

But what do we mean by risk in the context of investing? The word is often used but seldom made clear, so I hope can provide a more helpful explanation.

What risk really means

At the simplest level, investment risk means the likelihood of losing money. That’s straightforward enough but underlying this ‘overall’ risk are layers of individual risks that generally fall into two camps: market or ‘systemic’ risks and ‘idiosyncratic’ risks. If this sounds a bit technical, don’t worry there’s a relatively simple explanation for both!

Systemic risk affects all or a large group of investments and is driven by universal economic factors – the growth of the economy, interest rates, inflation and so on. For instance, if there is a severe recession the decline in economic activity is going to affect most sectors of the economy and individual companies.

Idiosyncratic risks relate to one or a small number of investments. For instance, a new competitor entering a sector might damage the prospects of the incumbents, as could the imposition of new regulations. In addition, a single company could be subject to any number of specific risks in its operations and could be a victim of misfortune or scandal.

The value-risk relationship

There is also the broader concept of whether an asset’s valuation accurately reflects this network of risks. Efficient Market Theory (EMT) states that stocks always trade at their ‘fair value’ at any given time using all available information, making it impossible for investors to purchase at overvalued or undervalued prices.

EMT is widely disputed as swings in investor sentiment – either over-optimism or excessive pessimism – seem to play a significant role in valuations on a day-to-day basis. If that’s the case then it adds another, almost random, factor of ‘market mood’ to the risk mix!

Measuring risk

The complex nature of risk makes it difficult (some would say impossible) to measure precisely, hence the term often becomes nebulous, even unhelpful, to investors starting out. Risk is often described and measured by professional investors using historic volatility – the extent of past ups and downs in price. But this only tells you so much. Investors shouldn’t necessarily take comfort in a small range of price movements as volatility could increase in the future.

What we do know is that some asset classes are less volatile than others – for instance, a bond, which represents the borrowings of a company, is less risky than an equivalent share whose fortunes is dependent on profitability rather than solvency. In addition, certain areas carry extra risks – for instance emerging markets which can be prone to more political uncertainty and fluctuations in the values of their currencies.

It would be great if you could get superb long term returns without taking any risk, but unfortunately, that’s not possible. The greater return you seek the more risk you need to take.

Mitigating risk and profiting from investing

Although we are left with the unsatisfactory conclusion that we can’t pin risk down entirely, there are some effective ways we can minimise and mitigate risk in order to better benefit from long term investing.

• Time is generally an investor’s friend and is particularly beneficial in terms of mitigating systematic risks. Invest for one day and the chances of a positive return are pretty much 50/50 but invest in global stock markets for 10 years and studies have shown the odds rise to over 90%. This is based on historic data, so it must be pointed out that the future may not be like the past.
• Diversification, spreading your money across lots of different investments, helps reduce idiosyncratic risks. Not being reliant on one or a small number of company shares, or one sector or geographical area, is sensible. Ideally, various investments making up a portfolio should be ‘uncorrelated’ with each other, in other words, they are affected by different sets of risks so are less likely to move up and down in tandem.
• Using volatility advantageously is another trick investors, particularly first-timers, have up their sleeve. Monthly investing can help ensure you are not buying at a market peak and average out the price you pay for assets. Market dips will potentially help rather than hinder returns. Another strategy is buying after markets have fallen a lot – when other investors are panicking. This tends to be a good time to invest because investments suddenly become much cheaper, though we would caution that market timing is notoriously difficult.

Investing with these principles in mind can make the experience of investing a lot more comfortable. Risk is inevitable when investing but it is manageable. It is also necessary in order to make the most of your money. This is why investing is distinct from gambling – it’s about stacking the odds in your favour rather than against you. While there are no guarantees, getting a few relatively simple things right should mean you have an excellent chance of long-term success.

Risk is personal

Everyone has a different appetite for risk. It’s unique to you and often depends on your personality and financial circumstance. Depending on your situation you may have a different level of ‘risk tolerance’ - the willingness to accept risk, a different ‘capacity for risk’ – how much you can afford to risk, and different ‘needs’ to take on financial risk – based on your short and long term aims and objectives. These clunky terms describe the basic point that an individual’s personality and circumstances dictate the amount of risk they take on.

There are two main things to bear in mind when assessing your own risk tolerance: Financial circumstances and time horizon. The less money you have and the shorter time you have the less able you are to take on risk. Those with little or no savings or, even worse, significant expensive debt should not be looking to invest. Their capacity for loss is essentially zero.

Similarly, someone with a lot of money that needs to use all of it in a relatively short time frame – for instance for a deposit on a house – shouldn’t be taking on investment risk either. Anything less than five years is generally considered too short.

There’s a need to match risk to circumstances appropriately, but financial literacy and confidence also play a role, as does personality. Some people are more predisposed to taking risk than others. Some people have a tendency to be overconfident, some are naturally more cautious. Either way, being over-optimistic or too timid, there can be negative consequences. The former can lead to excessive risk and losses that are hard to make up, the latter to missed opportunities and poor long-term returns.

Overcoming ‘risk aversion’

Over-anxiety about losses is particularly common amongst first time investors, which is quite understandable as it’s only natural to fear losing money. In fact, the human brain is hardwired to prioritise security and safety which leads to ‘loss aversion’, the tendency to be more emotionally affected by losing money compared to gaining it.

Think, for instance, how you would feel about stumbling across a £20 note. Probably happy but not overjoyed. But if you suddenly found you have mislaid a £20 note you would likely feel very annoyed, and the emotional reaction would probably be stronger than if you had found the equivalent sum.

This is the bias of the human brain in action and it’s what deters lots of more cautious or sceptical people from investing. Yet, taking risk is necessary to make the most of your money. The other side of the risk coin is opportunity, and with a bit of knowledge and confidence, we believe it is possible for lots more people to take the leap. We hope the resources in the Knowledge section of our website will help.

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