Risk in investing: the importance of understanding how risk shapes your returns

One of the most common reasons for hesitancy around investing is that it is perceived as risky.

To a certain extent, this is true. If you are a beginner investor, used to the security of cash savings, taking your first steps into the world of stocks and shares inherently carries with it greater risks, at least in the short term. Even the most popular stocks and funds can see their value decrease in nominal terms, something that can’t happen with cash savings.

But when it comes to investing, risk is a complex phenomenon. It is inextricably linked to reward, and it isn’t one-dimensional.

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There are various different forms of risk. One of these is the risk of doing nothing, as Andrius Makin, associate portfolio director, fund research at Killik & Co, explains.

“Investors are generally aware of the risks of investing in equity markets, but they don’t necessarily think about the risk of doing nothing, which is inflation risk,” he says.

“Over long periods of time, equities have the best chance of beating inflation. While bank accounts or money market funds provide a return, this can lag inflation and see the buying power of your portfolio eroded over time.”

In investing, the potential for superior, inflation-beating returns is generally the reward that investors receive in exchange for taking more risk.

“Risk is not the enemy,” says Dan Moczulski, UK managing director at eToro. “Done right, it is the price of returns and the driver of wealth creation.”

On 9 April, the Risk Warnings Review published its final report into risk warnings on financial products, like funds and investment trusts.

It found that generic warnings like ‘capital at risk’ had become commonplace throughout the industry, with these warnings failing to do what they are intended to: educate potential investors about the risks inherent in an investment product, without putting them off investing.

The report highlighted that while warnings like these could potentially scare away inexperienced investors, they are also typically ignored by more experienced ones.

Instead, it suggests that risk warnings should focus on educating investors proportionately and in clear, plain language both about the potential risks of losing money, but also of the possibility of superior returns over the long term.

“UK consumers have long been bombarded with stark, one-sided risk warnings when it comes to investing,” said Moczulski. “While transparency is important, this kind of messaging in isolation without equal emphasis on the long-term benefits of investing just risks putting people off altogether.”

The different types of risk in investing

Makin says that risk will typically manifest in one of two ways for investors: permanent capital loss, and volatility.

“Permanent capital loss can occur because of ‘specific’ or ‘un-systemic risk’, in that it affects individual companies or investments.

“It’s very different from volatility, because volatility is part and parcel of investing,” he says.

One of the best ways to illustrate these two types of risk is by thinking about arguably the archetypal ‘risky’ investment: cryptocurrency. Buying Bitcoin carries two forms of risk.

The first is that its value could collapse to zero. Bitcoin is now very heavily adopted by global business and financial institutions, as well as some nation-states, so it’s unlikely that its value will collapse this far, but the notion that Bitcoin has no inherent value is a critique that is still levied at it (and at other less established cryptocurrencies) by detractors. This is the risk of permanent capital loss.

But a look at historical Bitcoin prices will also tell you that it is a very volatile asset. From one month, or even one day, to the next its value can rise and fall substantially. As such, it is hard to predict any confidence that your investment will be worth more tomorrow than it is today, even if Bitcoin prices have been trending upwards over the long term.

There are various sources of risk, whatever kinds of asset you invest in.

“Risks take many forms, from market swings and company failures to inflation, interest rates, regulation, and geopolitics,” says Moczulski.

Before buying any stock, or fund, it is important to understand the risks that they pose. This isn’t because you should necessarily avoid risky investments full stop, but because by understanding the different risks your investments carry, you can construct a portfolio that is resilient to a wide range of potential shocks.

Short and long term risk

Another way of looking at risk is to consider the time frame that you are thinking about.

Often what is meant by ‘risk’ is short-term volatility. Investing in a broad stock market index through a tracker fund might lead to the value of your investment falling in the short term.

However, over the long term (as a rule of thumb, five years or more) the stock market tends to gain in value.

The Risk Warnings Review specifically acknowledged this in its report. It cited research from financial services research firm The Wisdom Council testing alternative variants on risk warning wording that accounts for these long term trends, such as: “Historically, money invested for more than five years grows more than cash savings. Your investments can also fall, so you might not get all of your money back.”

Moczulski says: “Helping people understand that markets fluctuate in the short term, but have historically delivered growth over the long term, is key to building confidence and improving financial outcomes for all.”

How to manage the risk in your investments

While the various forms of risks to our savings and investments can’t be eliminated, “they can be understood, managed, and combined intelligently,” says Moczulski, “because adding different risks together through diversification can actually reduce overall risk.”

Risk to investors is either systemic, or un-systemic. Systemic risk applies to nearly all assets and is outside an investor’s control. “There’s geopolitical tensions, or changes in interest rates or inflation. It’s very difficult to plan for, and it’s generally accepted that systemic risk can’t be diversified away. Within reason, whatever you’re invested in is likely to be impacted to some extent,” says Makin.

But un-systemic risk can be controlled by diversifying your portfolio. “That means you don’t have too much exposure to a specific company if something unexpected happens,” says Makin.

Being intentional about the risks you are taking – and why – is another good starting point to addressing the risk in your portfolio. “The key is knowing your own risk appetite,” says Moczulski. “This is shaped by your goals, your time horizon,and your comfort with potential losses. Ask yourself: are you happy to risk losing 10% if it means the chance to gain 35%?”

Those who answer ‘no’ to this question are likely to have a more conservative approach to risk.

“A long-term investor who can stomach volatility may choose equities or emerging markets, while someone more cautious might prefer fixed income or dividend stocks,” says Moczulski. “The point is not to avoid risk, but to take the right risks for you.”