Calculating investment risk: What plays a role?Published: July 14, 2020 by Jennifer Armstrong
When investing, we all know that capital is at risk. We’ve often talked about understanding your risk profile and the level of risk you should take when investing. But what affects how risky an investment is?
Understanding the risk of an investment can help you gauge if it’s the right investment for you and how it’ll change the balance of your portfolio. Numerous factors affect how risky an investment is, fund managers will use multiple ways to analyse each investment. However, one of the simplest places to start is by looking at the asset class.
The four main asset classes of investing
When reviewing investment portfolios, there are usually four main asset classes:
1. Cash: This is the least risky asset, but also delivers low returns. As returns are often lower than inflation, the value of money can decrease over time in real terms.
2. Bonds: Both government bonds and investment-grade corporate bonds are considered relatively low risk. With a bond, you’re effectively lending money in exchange for a fixed rate of interest. While a lower risk than stocks, if a company defaulted on payments you could still get back less than you invested. Bonds with a higher yield are riskier as they have a higher risk of default.
3. Property: Investing in property is often seen as a sure way to deliver returns, but it still comes with risks. An investment portfolio may hold commercial property and rise in value either from rental income or rising property prices. Property can be harder to sell should you need access to capital.
4. Shares: Finally, shares are the riskiest asset class of the four, as markets are unpredictable. However, the risk of different shares varies hugely. As with bonds, those with higher potential yields are typically the riskiest. The unpredictability of stock markets means a long-term time frame is essential when investing.
A well-balanced portfolio will typically include a mix of these assets. This helps to spread the risk and limit short-term volatility. For example, if stock markets are experiencing volatility, holding some of your capital in bonds can reduce the impact. This is why when you read headlines claiming stock markets have fallen by a certain percentage, an individual portfolio is unlikely to have experienced a fall to the same scale.
Even ‘high risk’ portfolios will invest some of their capital in bonds and property to create balance, likewise, a ‘low risk’ portfolio is likely to have some exposure to stocks.
Specific risk vs market risk
When looking at individual assets, there are numerous risks to consider, these can be broadly split into two areas: specific risk and market risk.
Specific risk refers to the risks within a company and the volatility their shares experience. All companies will experience some volatility, but, once again, this can vary significantly. Established and mature businesses, for instance, are less likely to have severe bouts of volatility than firms that are still in the growth phase. Specific risk can be analysed by looking at the profits, areas of investment, sector it operates in and more.
On the other hand, market risk affects the whole market and can be far more difficult to track. For example, in March this year, whole markets fell as a result of the Covid-19 pandemic, even when the prospects of some companies within those markets remained unchanged. This is why we not only spread investments across companies but different sectors and geographical locations too, helping to reduce exposure to volatility.
Building a diversified portfolio that matches your risk profile
When you review your investments, you should start by looking at your own risk profile. This allows you to build a portfolio that suits your goals, investment time frame and overall attitude to risk. Diversifying investments, across asset class, sector and geographical locations helps to create a balanced portfolio that’s linked to your risk profile. When we work with you when investing, this is why we start with your aspirations.
Please contact us to discuss your investment options, including how risk can be managed within your own portfolio.
Please note: The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.