11 Apr 2023

What is investment risk?

Everything you need to know about the types of risk you'll face when investing and how to avoid scams.

Megan ThomasResearcher & writer

In this article

Why is investment risk important?
How risky are your investments?
What else makes an investment risky?
What can I do about investment risk?
How do I rebalance my investment portfolio?
How can I spot an investment scam?

Why is investment risk important?

Regardless of why you're investing - whether you're a keen stock market hobbyist or simply saving for retirement - it's important to understand risk.

Specifically, you should understand your own attitude to risk.

Some people are happy to live with calculated risks if it means the chance of a higher return in the long run; others don't want to lose money under any circumstances. But being highly risk-averse can itself cause you to lose money.

Here we explain the different types of risk, whether you should be concerned and what you can do.

How risky are your investments?

No asset is truly risk-free, but different assets carry different risks and potential for reward. If your portfolio contains a higher proportion of risky assets, you can expect sharper swings in its value.

Cash

Cash is one of the least risky investments but it tends to deliver low returns, which means the value of your money is more likely to be eroded by inflation (see 'Inflation risk' explained below).

Find out more: cash as an asset class

Bonds

One step up the risk ladder are government bonds, or gilts, followed by investment grade corporate bonds, where you effectively lend money to large companies in exchange for a fixed rate of interest.

High-yield bonds, also known as 'junk bonds', are an even riskier option because they deal with companies seen to have a high risk of default.

Find out more: gilts and corporate bonds explained

Shares, also known as stocks or equities, are seen as among the riskiest assets, as stock markets can be highly unpredictable. But some markets are considered riskier than others.

Investing in developed markets such as the UK and the US is considered relatively safe compared to other equity markets, although these contain their share of higher risk options, too, while emerging markets (such as Brazil, China and India) equities are likely to be more volatile.

Buying shares in geographical regions less-frequented by investors can be expensive and the shares can be comparatively illiquid.

Find out more: investing directly in shares

Property

Investing in commercial property, such as offices, supermarkets and warehouses, can grow your money through rental income and growth in the value of the property you own, but can be illiquid - meaning it can be hard to sell if you need to access your money.

Find out more: investing in commercial property

Commodities

There's an almost endless list of commodities you can invest in, from crude oil to copper to cereals.

As it's usually impractical to directly buy commodities, many people invest through exchange-traded commodities funds. Another approach is to invest in firms that extract commodities, so you indirectly benefit from price rises.

Gold has long been relied upon as a safe haven, as its price tends to rise when stock markets are struggling. But it's not risk free - gold prices can fall, gold doesn't pay dividends, and you'll need to pay to store physical gold (funds that invest in gold are also available).

Silver is more volatile and experiences larger price changes, as well as similar drawbacks to gold.

Commodities are typically a very volatile asset class and hence not necessarily suitable for beginner investors.

Find out more: how to invest in gold

Cryptocurrencies

There are many cryptocurrencies, of which Bitcoin is one. Their prices have been extremely volatile in recent years, rising and falling in a short space of time, so they are one of the riskier investments.

Cryptocurrencies aren't covered by the Financial Services Compensation Scheme, so there's not just the risk that you'll lose money from volatile prices but also the risk you'll lose money to many - which are very common with cryptocurrency.

Find out more: bitcoin and cryptocurrencies explained

What else makes an investment risky?

Beyond the risks posed by the assets themselves, there are other risks investors should account for:

Inflation risk is the threat of rising prices eroding the buying power of your money.

If you hold your money in a savings account, chances are that inflation will increase at a higher rate than you can gain in interest. So, after a long period of time, there could be big gap between what your money used to be able to buy and what it could buy now.

By taking on some risk by investing, you could mitigate the impact of inflation with the possibility of higher returns.

Find out more: are you ready to invest?

If you invest in individual company shares, there's always a chance that unforeseen events will scupper your portfolio. Some shares will fluctuate more than others, but no company is completely immune to volatility.

The key to avoiding specific investment risk is diversification.

The best and cheapest way to spread your risk is to invest in pooled investment funds, such as unit trusts or investment trusts. They're called pooled investments because you pool your money with other savers to buy a wide range of shares.

Market risk is where an entire stock market begins to fall.

If sentiment turns against UK shares, for example, share prices could start to fall across the board, even if the prospects for particular sectors or companies are unchanged.

A good way of avoiding market risk is to invest your money gradually and invest for at least five years, giving your investments time to recover.

You can also reduce market risk by investing in a variety of stock markets around the world.

If your money is invested in stock markets outside the UK, you'll face currency risk. Wherever your money is invested, it will have to be converted into sterling when you want it back. As a result, movements in the exchange rate will affect the value of your investment - this can work in your favour or against you.

You can limit currency risk by diversifying, for example through an international fund that spreads its investments around the globe, or by hedging your position - ie, investing in currency-related investments to ensure that you never lose additional money due to movements in the currency.

Some funds that invest overseas do the hedging for you. Alternatively, you can avoid currency risk by sticking to the UK, but this increases your market risk.

There is a huge variation in the investment performance of individual managers of unit and investment trusts.

So while some of the best fund managers may consistently beat their benchmarks and deliver the kind of returns that you hope for, they're extremely difficult to pick.

Buying an index-tracking fund should remove the risk of picking a bad manager, as these simply match their chosen index. Index trackers tend to have lower charges than funds where managers try to beat the market.

Find out more: active vs passive investment

What can I do about investment risk?

The greater return you want, the more risk you'll usually have to accept.

The more risk you take with your investments, the greater the chance of losing some or all of your initial investment (your capital). If you're saving over the short-term (less than five years), it's probably best not to take on as much capital risk.

Over the long term, investing in share-based assets has historically proved to be the best way for providing growth that outstrips inflation. There is a risk attached but, when you invest over the long-term, there is more time to recover your losses after a fall in the stock market.

Diversifying your portfolio will reduce the impact of any one asset's price swings on your overall returns. That means investing in many different types of assets, spread over different countries and industries.

Find out more: how to diversify your portfolio.

How do I rebalance my investment portfolio?

It's possible that your priorities or risk appetite may change, and your portfolio might need to be altered to reflect this.

But generally, you'll need to re-assess and rebalance your portfolio annually. Rebalancing involves selling or buying assets, returning to the original proportions of asset types and ensuring you're not taking on more risk then you thought you were.

This is necessary because, over time, your investments may fall out of sync with your original asset allocation; this tends to happen when one asset, usually equities, grows more quickly than the others.

If you have a financial adviser, they'll rebalance your portfolio for you. Some investment platforms offer managed portfolios, which will also take care of rebalancing.

Poorly performing investments

Generally speaking, you would also check how your investments are performing and consider selling long-term underperforming assets.

But don't panic sell - this is likely to do more harm than good, as you'll realise losses and miss out on any recovery.

Try to resist the temptation to tinker with your portfolio; instead aim to rebalance after six months or a year. An increasing number of investment platforms now offer smartphone apps, but these can increase the temptation to shift things around more often than is helpful.

Find out more: investment platforms reviewed

How can I spot an investment scam?

Investors lose tens of millions of pounds each year to scams. These include outright scams, where you transfer money that is never returned, and schemes where the true assets, fees or level of risk aren't disclosed until after you've invested.

Certain types of investments, such as cryptocurrencies or exotic commodities, are often targeted by scammers. But also beware of 'clone firm' scams, where investors imitate genuine firms offering familiar investments.

Before making an investment, always do the following:

Check the Financial Conduct Authority warning list
Check the firm is on the Financial Services Register
Check the firm's permissions on the Register match the service you're being offered
Use the contact details on the Register to confirm you're dealing with the genuine firm
Check if the Financial Ombudsman Service or the Financial Services Compensation Scheme covers you

If you don't understand the product you're being offered, talk to an independent financial adviser (Which? members can also contact the Which? Money Helpline).