Reward entails risk. Investing has its risks in that you may lose or in extreme and rare cases all of your money. But not all investments are the same, and not everyone picks investments in the same way. Understanding the types of investments and their risk profiles are the first step in making good choices.
Let’s get the usual stuff out of the way. The value of investments can fall as well as rise. Investments should be treated with a long-term outlook with a minimum duration of 5 years.
Individual Shares – bigger Risk, bigger Reward
Investing in individual shares is the type of asset that that has the most risk associated with it (in a meaningful context – we’re not talking about antique or classic car investing here).
However, not all shares are equal. Some will do well, some won’t do so well. And some are exposed to more volatile economic environments.
Investing in UK-listed FTSE 100 or FTSE 250 shares is therefore deemed a safer prospect than say investing in companies located in Brazil (emerging markets). Likewise, even with UK companies, you can increase your reward and risk by investing in smaller companies such as those generally on the Alternative Investment Market. These companies could be the stars of tomorrow but the risk is that they may not become so.
A special mention for commodities – mostly viewed as the most risky asset class
Commodities are generally viewed as the most risky asset class. This is because they tend to be the most volatile in respect to the wider macro and political environment. Oil is a great example of this. However, commodities such as gold can actually be seen as less risk when times are tough and generally associated with safe haven investing.
Investing in Property – safe as houses?
As they say, ‘safe as houses’ – property generally gives certainty and this is evidenced by price rises over a long-term basis. If an economy does well, property tends to do well. The general premise is that you will benefit from the rental income and potential appreciation in value. Investing in various properties (both residential and more commercial) is made easy with various funds which we’ll discuss a little later.
Bonds – OK, now we’re getting down to lower risk
Companies and governments will issue bonds and gilts respectively to raise money. In return for you lending them money, you receive interest (usually annually or semi-annually) on top of your original loan provided at the end of the agreed term.
Although – like shares and even property, there are areas of bonds that can provide you with more reward but also more risk. Ratings agencies will rate bonds and gilts – starting with A ratings and moving down to D ratings. As you may think – those with the lower-ratings come with greater reward through higher interest payments. But there is more of a chance you may not get your money back. These bonds promise higher returns (yields) but have a bigger risk – they are also known as ‘junk bonds’.
Cash – OK now we’re pretty much down to low risk but tiny reward
Cash in its purest form offers the lowest form of risk. Banked cash provides little risk (ensure the company that holds your money is covered by the Financial Services Compensation Scheme). However, the reality is that cash will generate very little worthwhile return. Interest rates have been rock-bottom for over a decade, and that doesn’t seem likely to change anytime soon.
The other factors
Beyond the asset classes themselves, there are also some other factors that are perhaps beyond your control but can impact the risk associated with investing. General market sentiment can have an impact (i.e. when confidence is low, prices generally fall) as well aspects such as the rate of inflation (if the cost of living increases, the real return on savings or incomes from dividends or interest falls).
Investing in a fund helps cut a large portion of the risk (most of the time)
Investment funds pool investors’ money together and will try to pick and choose that they believe to be the best investment opportunities. Funds can invest in all of these asset classes in various ways – either actively or passively (trying to mirror their overall performance). The combination of multiple investments in selected asset classes can help lower your risk and diversify your portfolio. There are equity funds, emerging market equity funds, property funds, commodity funds, mixed-asset funds and even multi-manager funds (a fund manager selecting from multiple funds). You should get the drift of this by now, so we’ll stop!
However, funds are not without risk. Some can perform worse than others despite investing in the same asset classes. But this is why like with anything you purchase, you need to do your homework! Homework on previous performance, the fund manager themselves and what they’re investing in!
Above all, you need to be clear on your own risk appetite balanced against your desired reward as this will guide what asset classes you invest in and how much.