Risk & Rewards of Investing

Every investment includes risk. That is, the risk that you could lose some or all your money. And different investments carry different levels of risk, so it is important you understand how much risk an investment has before deciding if it is right for you.

Also important to understand is that 'investment risk' is just one side of the coin - the other side being the 'investment reward'. Typically, the greater the risk involved in an investment the greater the potential reward (or return).

Case Study: Mr & Mrs Jones

Why are they investing?

• They want to support their daughter through university. She has just started secondary education.

What is their financial objective i.e. what do they aim to achieve from investing?

• They aim to have £20,000 available in 5 years.
• The amount available to invest is £10,000.
• So, the requirement is to turn £10,000 into £20,000 in a 5 year period.

Before investing, Mr & Mrs Jones need to consider their 'attitude to risk'. This will identify how much of their investment they would be prepared to lose. If the answer is 'none of it' then this rules out stock market investments and would lead to the 'low risk' options, possibly a cash ISA and a Savings Account. But whilst this would ensure the safety of their £10,000 the rewards are generally so low that the Jones' may not achieve their financial objective of £20,000.

Either their 'attitude to risk' or their financial objective will need to change.

This is one dilemma we all face, we need to find the balance where our 'attitude to risk' will give us a very realistic chance of reaching our financial objective.

There are different methods to managing risk. These include:

Diversification

Diversification is a technique used in investing to minimise risk by spreading your investment across a wide range of investment types. This ensures that you are not putting all your eggs in one basket as your risk is potentially reduced by investing in more than one type of investment.

Example:

Mr and Mrs Jones live up in the mountains where in the summer the area is visited by thousands of mountain climbers. In the winter these tourists are replaced by skiers and snowboarders. Mr and Mrs Jones wish to invest for their retirement and have been looking at buying shares in two local companies. One of these companies sells hill walking and climbing equipment, therefore, performance will be high in the summer months but poor in the winter months. The other company sells ski and snowboarding clothing and equipment so this company has a high performance in the winter months. Either company alone is not ideal for Mr and Mrs Jones to invest in, however, splitting the investment across both companies could reduce any risk associated with these weather dependent companies.

Asset Allocation

Asset Allocation just means how an investor spreads their investment across different assets or asset classes. The investment can be spread across different assets within the same asset class (e.g. you may invest both in UK and international shares) or the investment can be spread across different asset classes. This reduces the investment risk as it is unusual for the market in all areas to go down at the same time. Risks can be reduced by diversification. A financial advisor or stockbroker will be able to identify an asset collection that will suit your investing objectives and attitude to risk.

When investing there is the potential that you could loose some or all of your money.

That’s because the value of investments can fall as well as rise.

However, there are different ways to manage risk to suit your personal circumstances.

Before you think about investing you have to consider your potential losses and decide what you can or cannot afford to lose.

So, if you're thinking about investing, here are some things you might like to think about.

• Generally, the greater the risk, the greater the potential reward of the investment
• Beware of products claiming to provide a high level of return for a low risk
• Find out as much as you can about the type of investment you are interested in
• Different currencies constantly move in relation to one another so investments in international opportunities can change in value just because of changes in the currency exchange
• Inflation can reduce the buying power of your money in the future, for example you may need £40 in the future to buy a shopping basket that costs £20 today

It’s important to understand that ‘investment risk’ is just one side of the coin - the other side being the return and there are different ways to reduce the risk with investing.

For more information on investment risk and return visit the Learning & Research pages on natweststockbrokers.com