Understanding Investment Risk

When investing, risk is a fundamental concept which will affect all of your investment decisions. Whenever you invest your money, you are putting it at risk in some way. Whether that is in the act of actually investing, or the investments you choose, there will be risk involved. Therefore, you need to be aware of risk and try to understand it in order to choose the right investments for you.

What is Investment Risk:

You may have learned the definition from here: What is risk and return in investing. However, just as a reminder of what risk actually is: Investment risk is the uncertainty of financial returns from an asset.

Essentially, when you invest, the actual returns which you receive may differ from the expected returns. It is due to the risk which affects the investment.

Risk works in tandem with returns when investing. They are said to have a positive relationship. It is suggested the greater risk taken on, the greater the potential of expected returns. There is a risk-return trade-off  which can be used to justify your investment decisions.

Why you need to understand investment risk

When you invest, you set goals and aims. You have ambitions and ideas of what you wish to accomplish. Ultimately, returns may become the top priority to the decisions you make. It makes sense to aim for what you want to achieve.

However, if your sole focus is on returns, you may forget about the aspect which affects them – Risk. Every investment is subject to some element of risk, which leads to varying returns. Given that returns are unpredictable, it means risk becomes vital to every decision.

Risk is arguably the most important factor when investing. By having an understanding of risk, it enables you to measure and assess investments and decide if it has the right element of potential returns given the risk being taken. It allows you greater control over your decisions, as you can begin to set your own level of investment risk and choose the types of assets which will match that risk. It also enables you to manage the risk you take on where you can aim to minimise, spread, and reduce that risk.

Understanding risk can also present an opportunity. It doesn’t always have to be negative. By having an idea of risk and how it can affect an investment, you may be willing to take on more risk. You may find that an asset isn’t as risky as believed, which could help you to choose investments which aim towards bigger rewards.

Essentially, risk is a factor which will affect every investment. By understanding risk, it allows you to make the right choices for you. Understanding, choosing, and managing risk gives you the closest possibility of achieving returns as close to what is expected, thus giving you the greatest possible chance of success when investing.

How investment risk works

Risk considers the uncertainty of returns of an investment. When the actual returns differ from the returns which were expected, it means that asset was subject to, and affected, by risk. You may wonder how investment risk actually affects returns.

The general definition of risk is a situation involving exposure to danger. In investing, it is essentially no different. When considering how risk affects your investments, it fundamentally comes down to the factors which can potentially impact returns. As an asset is exposed to risk, it means that there is something which can be a threat to that investment which can negatively affect returns.

There are a number of types of risk, where every investment has differing amounts which they are exposed to. Some assets can be considered to be virtually ‘risk-free’, as there is very little influence which will alter their expected returns. However, other investments could be subject to a number of risks, which means that returns could vary massively.

The greater the impact of the factors which can affect an investment, the riskier it is likely to be. This is because there is an increased amount of negative influences which could affect potential returns. It leads to greater variance between what was expected and what was actually returned. Knowing how risk can affect an asset enables investors to being able to factor it in to their own decisions.

Having an idea of how risk affects an investment provides a solid basis to understanding risk. The next step is to be able to evaluate the risk of an investment. There are ways to outline risk which allows an investor to measure and assess just how risky an asset could be.

Measuring investment risk

Being able to apply numbers is a useful tool for investors to understand the risk of an investment. Whilst there is no exact measurement which indicates the exact risk of an investment, there are ways in which to quantify risk.

Volatility is the most commonly used form of measuring risk. It is used as a proxy which would allow you to get an idea of the level risk an asset may have.

Volatility and risk

Volatility measures the difference in returns from an asset. It takes the actual returns and the average returns and measures the standard deviation between them. The volatility is given as a percentage to represent how likely actual returns differ from the average of what was expected.

As returns are said to coincide with risk, it suggests that those assets which show greater volatility are said to be riskier. In other words, assets which have higher volatility – larger variation from the average in their returns carry greater risk. Whereas those with returns closest to the average are considered to be lower risk.

Example:
Asset A Returns Asset B Returns
Year 1 10% 5%
Year 2 -8% -2%

Asset A has larger variations in comparison to Asset B. There are more up and down movements in the returns. It suggests that whilst there is potential for greater returns in Asset A, there is greater chance that there are more risks affecting the expected returns. Therefore, Asset A is said to be riskier than asset B.

Volatility is a useful indicator of risk within an asset. It shows how returns can differ in an investment. It suggests that the greater amount of risk you take on, the greater returns could be but also the less likely that returns are guaranteed. Volatility is a useful guide for your decisions. It can  help you to choose assets which suit your comfort levels of risk.

However, it is important to consider that volatility doesn’t tell us the full story. The differing returns fail to identify the types of risks which the investment is exposed to and the impact those risks will have.  Additionally, volatility has equal focus on both the negative and positive returns as well as reacting to extreme events, which can cause an inaccurate representation of risk in an investment. Therefore, investment risk should also be assessed to help understand how risk affects an asset.

Assessing risk

As we know, risk is the exposure to danger. Whilst volatility is a useful indicator, it fails to tell the full story on just how risk is affecting an asset and its returns. There needs to be a way to look in depth at the how risk affects an investment. Therefore, assessing risk helps to recognise just how risky an investment may be.

Assessing risk takes a more subjective approach, in which the investor uses their own judgement to weigh up an asset and determine its risk. By assessing the risk of an asset, it means the investor is able to:

  • Identify the types of risk which can affect the investment
  • Evaluate the impact each type of risk may have
  • Determine the impact risk could have on expected returns

By assessing risk, it allows investors to have an indication of not only the current risks, but those which could affect the business in the future. It enables investors to really understand the investment and determine the risk they would be taking on.

Investing with risk

Once you have an understanding of how risk works and how it can be measured and assessed, it is possible to begin to invest whilst factoring risk into your decisions.

As an investor, you can begin to define, set, and manage your own level of risk. Firstly, you will need to consider how risk will affect you. You can determine your personal attitude to risk and how much risk you can take on. Once you have an idea of this, you can begin to think of the types of investments and how you can decide on them based on risk.

Once you have an idea of your own risk profile, you can begin to consider how you can deal with risk when you invest. It is not possible to fully get rid of investment risk. There will always be some element which could potentially affect its returns. However, risk can be managed. There are ways to reduce, spread and eliminate some elements of risk. Managing risk can help you try and achieve returns as close to what is expected.

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