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Understanding investment
risk
Investment
risk is the chance you take on making or losing money with any investment you
make. Generally, the level of investment risk and eventual reward go hand in
hand - the greater the risk you take, the more you potentially stand to gain,
or lose. When considering your next investment, it is important to evaluate
your own individual trade-off between investment risk and return. There are a
number of different types of investment risk - when you are thinking of your
next investment it is important to take each into account.
MARKET
RISK
Unlike money invested in a bank or building society, investments in a stock
market will always carry the risk of some short-term volatility affecting
your investments, irrespective of the relative strength of the individual
companies you are invested in. This is one of the reasons why you'll see
investment companies using phrases such as 'the value of your investments and
the income from them can go down as well as up'. However, while there are no
guarantees, the reason stock market investment has proved so popular is
because historically, despite short-term volatility, major markets have moved
up strongly over the long term. One of the key ways to combat the effects of
market risk is to therefore understand that there will be periods when the
value of your investments will fluctuate, but remaining invested in them over
the long term - typically 5 to 10 years - may give them a better opportunity
to perform.
LACK
OF DIVERSIFICATION
Allied to market risk is the risk that comes with investing all your money in
one place , which is classically known as 'putting
all your eggs in one basket'. Over certain periods of time, one or more
sectors of the market will tend to outperform the overall market. While it
might be tempting to invest purely in such sectors, were their fortunes to
change and they started performing badly, the value of your entire portfolio
would fall with them. This risk can therefore be reduced by ensuring you are
invested in a diverse range of sectors, so that overall, those which you are
invested in that fall, are likely to be balanced or outweighed by others that
rise.
INTERNATIONAL
EXPOSURE
Just as market sectors within one country will not always perform in the same
way, markets across the world will also not always correlate. There may be
times when for example European markets will be stronger than those in the
UK, or emerging markets such as those in Asia will perform better than large
established ones, such as in the US. Including funds in your portfolio that
concentrate on international markets can therefore be a further way of
increasing diversification in your portfolio, with the aim of reducing your
overall investment risk.
INTEREST
RATE RISK
Fund managers will always monitor interest rates. As interest rates
fluctuate, they will have a key bearing on the price of equities and bonds.
For example, in a period of interest rate rises, the balance of risk and
return with regard to cash investments may become more attractive and as a
result the price of stocks as well as bonds may come down. So again the
message is to remain diversified, across different investments such as
equities, bonds and cash to help reduce interest rate risk.
INFLATION
RISK
This is the risk that comes from doing nothing. As inflation averages
approximately 31/2 % in the UK,
uninvested money will on average lose that much of
its value every year. So whether you are a cautious investor that prefers the
security of bank or building society accounts or a more aggressive investor
who is willing to accept the market risks inherent in investing in bonds and
equities, there are clear benefits in staying invested. The cautious investor
preferring bank and building society accounts is exposed to the risk of
inflation over the longer term.
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