Investment risk explained: what you need to know

Investment risk is the probability that an asset's actual return will differ from its expected return, including the potential to lose some or all of the original capital invested. It’s the fundamental measure of uncertainty in the financial markets, driving the balance between potential losses and rewards.

Financial markets are inherently volatile, constantly reacting to a complex web of factors. Economic data releases, geopolitical events, changes in central bank interest rates, shifts in consumer sentiment and more can cause the value of assets to rise or fall, and changes can be difficult to predict with any degree of certainty. 

When you invest, you accept this volatility in exchange for the chance to grow your wealth over time. No investment is entirely free from risk, and even seemingly stable assets are subject to forces beyond an individual investor's control. Recognising and accounting for the fact that risk is a built-in feature of investing is the first step toward managing it effectively.

Investment risk comes in several different forms, with market volatility the most common:

• Market volatility: This refers to the rate and magnitude of price changes in an asset or market over time. High volatility means prices are fluctuating rapidly, which can lead to unpredictable short-term outcomes.
• Market risk: There is always the possibility of experiencing losses due to factors that affect the overall performance of financial markets. Economic recessions, political turmoil, or broad changes in interest rates can all trigger market-wide declines.
• Capital risk: This is the potential that you could lose some or all of your original investment. Unlike fixed-term cash savings where your initial deposit is protected up to deposit guarantee scheme limits, investing always carries the risk that your capital will decrease in value.
• Inflation risk: Also known as purchasing power risk, this is the danger that the return on an investment won’t keep pace with the rising cost of living. You can learn more about how rising prices affect your money in our guide to inflation and interest rates.
• Liquidity risk: This refers to the risk that an investment can’t be bought or sold quickly enough to prevent or minimise a loss. Physical property, for example, generally carries a higher liquidity risk than publicly traded shares.
• Credit risk: Sometimes called default risk, this is the possibility that a bond issuer or borrower will fail to make their required payments. This is particularly relevant when evaluating high-risk investments compared to lower-risk, regulated assets.

The risk-return relationship is a fundamental principle in finance. It states that the potential return on an investment should increase as the level of risk increases. Investors expect to be compensated for taking on additional uncertainty.

If an asset carries a high probability of losing value or experiencing severe volatility, investors will demand a higher potential reward to justify holding it. Conversely, investments with a lower risk of capital loss typically offer lower potential returns. This dynamic is why a highly volatile technology share might offer the chance of substantial gains, while a fixed-term savings account provides a more modest but predictable return. .

Understanding this balance can help you align your portfolio with your personal financial goals. You must decide how much uncertainty you can afford to tolerate and evaluate this against the return you hope to receive. 

Here is a summary of general risk levels by asset class:

While you can’t eliminate market uncertainty, you can take practical steps to protect your portfolio. Managing investment risk effectively involves balancing your pursuit of growth with protective measures. Here are some strategies you could follow:

• Diversification: This strategy involves spreading your money across different asset classes, industry sectors, and geographical regions. If one area of your portfolio performs poorly, the stability or growth in another area can help balance out those losses. It is the financial equivalent of not putting all your eggs in one basket.
• Time horizon: The length of time you plan to hold your investments plays a crucial role in risk management. Historically, holding investments over a longer period has helped smooth out the impact of short-term market volatility. By keeping your money invested for multiple years, you may give your portfolio time to recover from sudden market dips (but it’s important to note that you can still lose money on a long-term investment).
• Asset allocation: This is the process of dividing your investments among different categories, such as shares, bonds, and cash. Your ideal asset allocation should reflect your personal risk tolerance and financial goals. A younger investor might tolerate a higher allocation of shares, while someone approaching retirement might shift towards more stable bonds and cash savings to preserve capital.

The service you use to invest is just as important as the assets you choose and strategies you employ. Ensuring your chosen provider is regulated by the Financial Conduct Authority (FCA) means they must adhere to strict operational standards. While this does not remove market risk, it protects you from unregulated scams and means providers are required by law to maintain clear, transparent communication.

If you prefer to avoid the uncertainty of investments potentially going up as well as down, holding a portion of your wealth in cash savings provides a more predictable foundation. Cash accounts are not exposed to investment risk, meaning your initial deposit will not decrease in value due to stock market volatility.

When considering cash savings, you’ll need to plan for inflation. While your capital is shielded from market dips, its purchasing power can erode over time if inflation outpaces your interest rate. Choosing fixed-term accounts often provides a higher, predictable return to help offset this. 

If you are looking for a predictable return on your cash, Raisin UK offers access to a wide range of savings accounts from our partner banks. You can quickly compare rates and open fixed-term or easy-access accounts through a single, secure platform. With the Financial Services Compensation Scheme, money held in your Raisin UK Transaction Account and our partner banks is protected up to £120,000 per person, per banking group. 

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