Investment risk is the possibility of losing some or all of your original investment. Most investments will fall as well as rise in value through time. The higher the risk of an investment the more you should expect it to swing in value.
Do different types of investments have different levels of risk?
When investments are combined, risk can be reduced through a process known as diversification. As investments respond differently to each other at any one time, the swing in value from a portfolio of investments is often less than the swing of the individual investments. This can be illustrated with a simple example.
Imagine a desert island with two distinct seasons and two separate businesses. One specialises in selling umbrellas and the other specialises in Bermuda shorts. In the sunny season, the Bermuda shorts business grows quickly as consumers demand more shorts for the good weather. The share price of this business tends to increase in this sunny period.
However, when the rainy season arrives, the Bermuda shorts business struggles and the umbrella company thrives. During this rainy season the shorts business share price falls and the umbrella company share price rises.
Over time, both businesses increase their worth and share price as the population of the island grows and they find better, more efficient ways to make their goods. By making an investment in either business, over time the value of your portfolio would have grown. However, the value of your portfolio will rise and fall with the seasons.
By holding both companies the rises and falls would have cancelled each other out, reducing volatility and providing a much smoother return.
Although the above scenario provides a light hearted and over simplified example, the principles apply in the real world of investment. Please note that positive return is not guaranteed when making any investment and you may get back less than the original amount invested.
Why take risk?
When we talk about risk, we are referring to a portfolio of many investments. Although individual investments may provide the opportunity of a lifetime, they could also become worthless with no chance of recovering any value if things go wrong. A portfolio of investments, like the Margetts Risk Rated funds, reduces the risk of a single investment having this effect through diversification, which allows more certain expectations for future value.
Investors are generally risk averse, meaning that greater returns are expected for taking additional risk. Intuitively this makes sense why would you take more risk unless there is potential for greater gain?
Historical evidence supports the theory that higher risk assets have generated higher returns over time. However, they have also provided periods where the value fell considerably more than lower risk investments. The below chart shows how a £10,000 investment has performed since 1986 when invested in a portfolio of stocks and shares in the UK stock market, a portfolio of bonds (which are loans to the UK government) and cash.
How much risk you should take will depend on your time frame for investment and your personal circumstances. Higher risk investments are only suitable for investors with a longer time frame as losses from these investments may not be recovered in the short term. A financial adviser will be able to help you assess the level of risk that is appropriate.