What Does Investment Risk Actually Mean?

Isn't investment risk just losing money?

That's certainly one of the risks.

If you invest £20,000 and later sell the investment for £15,000, you've experienced a financial loss.

That's easy to understand.

But there are other risks that aren't quite so obvious.

Suppose instead you keep £20,000 in cash for twenty years.

The balance might never fall below £20,000.

But if prices have risen substantially during those twenty years, the £20,000 may buy considerably less.

Your number hasn't fallen.

Your purchasing power has.

Different problem.

Different risk.

That's why:

"I don't want any risk"

isn't really enough information to build a financial plan.

Steve's observation

We tend to notice risks that make the number on the screen go down.

They're obvious.

£50,000 becoming £40,000 gets your attention rather quickly.

But some financial risks are quieter.

Your money can still say £50,000 while gradually buying less and less.

Not every financial risk arrives with a red minus sign next to it.

1. Capital risk

This is the one most people immediately think about.

Could I get back less than I invested?

With investments, the answer can be yes.

You invest £10,000.

Its value falls to £8,000.

If you sell for £8,000, you've crystallised a £2,000 loss.

With some particularly high-risk investments, it may be possible to lose all of the money invested.

That's why understanding what you actually own is so important.

The word investment covers an enormous range of things.

They don't all carry the same risk.

2. Volatility risk

Volatility describes how much an investment's value moves around.

Consider two imaginary investments.

Investment A

£10,000

£10,200

£9,900

£10,300

£10,100

Investment B

£10,000

£12,500

£7,500

£11,500

£8,500

Both move.

Investment B moves considerably more.

That greater movement is volatility.

Volatility matters because large falls can create both financial and emotional problems.

But volatility and permanent loss are not automatically the same thing.

An investment might fall and later recover.

Or it might not.

And if you need to sell while its value is depressed, what might otherwise have been a temporary fall can become a very real financial loss.

3. Concentration risk

This is the:

"Too many eggs in one basket"

problem.

Imagine putting all your investment money into one company.

Your financial outcome now depends enormously on that company's success.

If the company performs brilliantly, wonderful.

If it fails, considerably less wonderful.

Now imagine spreading the money across hundreds of companies, different industries and different parts of the world.

You're no longer depending on one company.

That's diversification.

The FCA describes diversification as spreading investments across different products and areas so that you're less dependent on any one investment performing well.

Diversification doesn't prevent losses.

But it can reduce concentration risk.

4. Market risk

Sometimes individual investments aren't the problem.

Whole markets fall.

Economic recessions.

Interest-rate changes.

Political events.

Financial crises.

Wars.

Unexpected global events.

Changes in investor confidence.

All of these can affect investment markets.

You could own perfectly respectable, profitable companies and still see their share prices fall because investors around the world have become nervous.

Diversification can help manage some risks.

It cannot guarantee protection when broad investment markets fall together.

5. Inflation risk

This one is particularly important because it doesn't always look like a loss.

Suppose you've got £30,000 in cash.

Years later, you've still got £30,000.

Nothing lost?

Not necessarily.

If the things you wanted to buy have become substantially more expensive, your money's real value has fallen.

This is inflation risk.

It doesn't mean cash is bad.

We've already covered why appropriate cash reserves are extremely important in Guide 2 — How Much Money Should I Keep in Cash Before I Invest?

It simply means avoiding investment volatility by holding cash doesn't mean you've eliminated every financial risk.

You've exchanged one set of risks for another.

6. Liquidity risk

Liquidity sounds unnecessarily complicated.

It basically means:

How easily can I turn this investment back into usable money?

Some investments can normally be sold relatively easily.

Others can be much harder to sell.

And occasionally an investment may technically be saleable, but only at a price you're unhappy accepting.

Imagine owning something supposedly worth £50,000.

That's lovely.

Unless you urgently need £50,000 and can't find anybody willing to buy it.

Access matters.

The FCA specifically encourages investors to understand how easily an investment can be sold or cashed out before committing their money.

7. Timescale risk

This isn't necessarily a separate investment product risk.

It's the risk of putting the wrong money into an investment.

Imagine investing money you need for a house deposit next year.

The investment falls 20%.

You don't have ten years to wait and see what happens next.

You need the money.

Compare that with somebody investing towards an objective twenty years away.

The same market fall can have completely different consequences.

That's why the FCA generally discusses mainstream investing in the context of longer timeframes, such as at least five years.

But remember:

five years isn't a guarantee.

It's not an expiry date for investment risk.

8. Behavioural risk

This one doesn't live inside the investment.

It lives inside us.

Markets fall.

You panic.

You sell.

Markets recover.

You buy again.

Markets fall.

You panic again.

Congratulations.

You've accidentally created the world's most exhausting investment strategy.

Human beings don't always make calm decisions when money is falling in value.

Fear, greed, excitement and FOMO can all influence behaviour.

That's why an investment strategy needs to be something you can realistically live with.

9. Risk of not achieving your objective

This is easily overlooked.

Suppose you need your money to grow sufficiently over twenty years to support a particular future objective.

You decide:

"I don't want investment risk, so I'll take as little as possible."

That might reduce market volatility.

But if the money subsequently doesn't grow sufficiently to achieve your objective, you've still experienced a financial risk.

This doesn't mean the answer is automatically:

take more investment risk.

It might mean:

save more;

invest for longer;

change the objective;

change the timeframe;

or reconsider the plan.

The important point is that avoiding volatility isn't the only objective.

10. High-risk investment risk

Some investments sit at the far end of the risk spectrum.

The FCA warns that high-risk investments can involve a very real possibility of losing some or all of the money invested, may be difficult to sell and are generally suitable only for experienced investors who properly understand and can afford the risks.

This is different from the normal ups and downs of a diversified mainstream investment portfolio.

We shouldn't casually put everything labelled "investment" into the same bucket.

And if something promises unusually high returns with apparently very little risk, that should make you more cautious, not less.

So how do I compare different investment risks?

Start by asking:

What do I actually own?

Then:

What could cause it to lose money?

How much could it reasonably move in value?

How diversified is it?

How easily can I sell it?

When will I need the money?

What happens to my plans if it falls substantially?

And how am I likely to react if it does?

Those questions tell you considerably more than simply being told:

"This is medium risk."

Does a risk score tell me everything?

No.

Risk scores can be useful ways of comparing investments.

But a number doesn't tell the whole story.

Two investments could appear to have similar risk classifications while:

holding different assets;

being exposed to different countries;

having different levels of diversification;

behaving differently in certain market conditions;

or having different liquidity characteristics.

So use risk ratings as information.

Don't treat them as a substitute for understanding what you own.

What Should I Do Next?

Take any pension or investment you currently own and ask:

What is this actually invested in?

Not:

"What's the provider called?"

Not:

"What does the statement say it's worth?"

Actually ask:

"Where is my money invested and what could make its value fall?"

If you can't answer that yet, don't worry.

That's exactly why we're building this Knowledge Hub.

Because once you understand what investment risk actually means, the next question becomes much easier to understand:

What happens when investment markets really do fall?

That's next:

Guide 9 — What Happens to My Investments if the Stock Market Falls?

The Open Door Wealth View

The word risk gets thrown around far too casually.

"Low risk."

"Medium risk."

"High risk."

Fine.

But what could actually happen to your money?

That's the useful conversation.

You might face:

market risk;

capital loss;

inflation;

concentration;

liquidity problems;

or even:

the risk of making a bad decision yourself when markets become uncomfortable.

You cannot remove every financial risk.

But you can understand which ones you're taking.

And once you understand them, you can make much better decisions about whether they belong in your financial plan.

Don't be frightened by the word risk. Make somebody explain what the risk actually is.

Suggested Call to Action

Have investments or pensions but aren't entirely sure what risks you're actually taking?

Before changing anything, understand what you own, where the money is invested, how diversified it is and what could cause its value to change.

Open Door Wealth can help you understand your existing investments before you decide whether anything needs changing.