When you make an investment you usually have some idea as to how you’d like it to perform. Often, you have an even clearer view of how you’d like it not to perform – typically, not to lose your money.
The expression ‘nothing ventured, nothing gained’ doesn’t tell the full story for investments. In reality, the higher the returns you want from an investment, the more uncertainty (or risk) you need to expose your money to.
So it’s important to understand that the more adventurous you are, the greater the chances that things don’t go the way you want. Risk and returns are part and parcel of investing.
What exactly do we mean by risk?
Risk is a measure of the chance of something not going to plan, usually for the worse. In everyday life, we are used to facing and managing all kinds of risks, such as slipping on an icy pavement or getting caught in a downpour.
For investments, we can think of risk as the likelihood of something you’ve bought not performing as you’d expected, particularly if it loses money.
There are many different kinds of investment risk, some we are well aware of but others that are less obvious. We’ll look at several of these later in this article.
What are returns?
For investors, return is a measure of what you get back, above the value of your original investment. While savings accounts generally offer specified rates of return, with many investments like shares rates of return will vary, especially over the short term.
As the value of your investment can go down as well as up, returns aren’t always positive, eg if you sell shares for less than you bought them for then your returns will be negative.
The relationship between risk and returns
There’s no hard and fast formula to calculate the exact link between risk and returns. Generally, the higher the level of investment risk, the higher the potential return and the greater danger of things going wrong.
Think about it – why is somebody paying you more for your money? It’s because there’s more chance that they won’t be able to pay it back. There is no guarantee that you will actually get a higher return by accepting more risk. If you are aiming to get higher returns from your investment than you would from say, a savings account, then you need to be prepared to take on some investment risk.
It’s also worth remembering that any returns or losses you make on an investment aren’t finalised until you’ve sold up and withdrawn your money. In the words of Lenny Kravitz, 'it ain’t over ‘til it’s over'.
Understand your risk profile
All investments come with a level of risk and don't always perform as expected. This is why you need to make sure you're making the choice that's right for you. It’s also worth thinking about how much money you’d be comfortable losing if things go wrong.
To get a better idea of your own risk profile, ask yourself:
- What do I need the money for?
While some investors may have no specific purpose in mind and simply enjoy the act of investing, others are ‘saving for a rainy day’ or have a set a goal for their money like funding retirement, paying for university fees or a wedding.
- How soon do I need the money?
The timeframe can have a major influence on investment decisions. Investing over a longer time frame, such as a minimum of 5 years, can help to offset short-term fluctuations in investment performance.
- Will I need access to the money sooner than I intended?
Due to some unexpected event, such as redundancy or serious illness, it’s possible that you might need to get your hands on your money sooner than you expected. So think about the ‘liquidity’ of your investments – whether you can sell your investment easily at any time. Certain investments require you to commit to locking in your money for a specified period. For other investments, any need to get your money out at a particular time can mean that you’re obliged to sell following a period of poor performance. Conversely, you may find that the opposite is true, and your need to sell follows a period of strong gains.
- Can I afford to lose all my money?
Of course, no investor wants to lose it all but some are better cushioned than others to withstand heavy, or even total, losses. As a rule of thumb, consider limiting yourself to not investing more than 10% of your net assets in investments where there is a real risk of losing a significant part, or all, of your investment. Your net assets for this purpose should be considered – savings, investments, property (that isn’t your primary residence), cars etc. minus any debt you owe. When considering high-return investments only invest if you’re prepared, and can afford, to lose all your money. Another important point to consider is whether some investment opportunities could in fact be scams. If it seems too good to be true, it might well be a scam.
How can you limit your exposure to risk?
Strike a balance
It’s important to find the appropriate balance of risk and return when making new investment decisions. If you’re seeking higher returns then you need to be willing to take higher risks with your money. On the other hand, if you’re not prepared to take more risks then you should look at investments aiming for more modest returns.
You should also consider your wider financial situation. If you already hold some higher-risk investments then it may be that taking a more cautious approach is appropriate. Conversely, if you have existing low-risk investments and a secure income, you may be happier with a more adventurous approach to new investments that can help you find the right overall balance.
Diversify your investments
Spreading your money across different types of investments, such as international shares and bonds, can reduce your risks. In a properly diversified set of investments, should any one particular investment or market be performing poorly, the performance of other investments can help to maintain overall returns and mitigate the impact of losses.
As diversified investors are less exposed to the peaks and troughs of short-term performance from individual investments, diversification can help to smooth out investment returns over time.
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