In this article we cover the relationship between risk and reward and why some risk is an advantage for medium to long term investments.
If risk wasn’t taken with investments it is likely that inflation rates would be higher than the rate of return on your investments. Rising prices caused by inflation reduce the purchasing power of cash over time so taking some risk to achieve good returns by investing in riskier assets is important to grow your investments in real terms.
Let’s start by looking at what different investments (or asset types) there are;
Types of Investments
Equities (or shares) are created when publicly listed companies sell shares of their company to external investors. Investment returns come from increases or decreases in the value of the company and also from income when part of the company’s profits are paid to shareholders as dividends.
Equities can potentially earn the highest return over the long term but are most likely to fluctuate in value in the short term and are considered a high risk investment.
ii) Alternative Investments
Alternative investments typically constitute investments made in unlisted companies (as opposed to those that are publicly listed on stock exchanges). Such investments can be made directly (e.g. a direct equity interest in such a company) or through an investment manager.
Investment returns come from increases or decreases in the value of the company and also from income.
Alternative investments are considered high risk investments
Investments in land and the facilities on it. Investment returns come from increases or decreases in the value of the property plus rental income.
Property is considered a medium risk investment.
iv) Fixed Interest
Includes securities such as government bonds, corporate bonds and debentures. These investments are essentially lending money to a government or corporation and in return investors get interest payments and increase or decreases in the value of the investment.
Fixed interest securities are considered a low to medium risk investment.
Includes money in bank deposits or short term money market securities. Investment returns come from interest payments and increases or decreases in value if invested in securities.
Cash is considered a low risk investment and is generally the most stable investment of the asset classes.
The most important factor when considering what to invest in is the relationship between risk and reward. Investments that have higher potential for growth also have a higher possibility of losses and are considered more risky, and those with lower growth potential have lower loss potential and are considered safer investments. The figure below shows the relationship between risk and reward:
To understand this relationship completely, you must know what your risk tolerance is and be able to gauge the relative risk of a particular investment correctly.
Some risk can be minimised by investing in a large number of different types of companies. This is known as diversification. For example, if an investor has £100 and invests this all in one company the specific risk is high as if this company fails the investor could lose all their investment. However, if the investor invests £1 in 100 different companies the specific risk is reduced as the chances of all 100 companies failing is much lower.
However much you diversify your investments, risk cannot be completely eliminated as some events affect the entire financial system, e.g. events such as the credit crunch or coronavirus pandemic.
Attitudes to Risk
There are many factors to consider when assessing your attitude to risk, such as:
- Financial Resources: assets, debts, income, expenditure, savings, protection,
- Age of investor and dependents
- Tax Status
- Objectives: purpose of investment, timescales, income or capital growth
- Goals and Aspirations: personal and financial
- Ability to Comprehend Risk: capacity for loss, previous experience, risk tolerance
There are a number of approaches that are taken by advisers to establish their client’s attitude, perception and capacity to take risk, including
- printed questionnaires
- computer-based assessments
- psychometric profiling
- numerical scales (1–10)
- open discussions; and
- graphical representations
Once attitude to risk has been determined, investors can typically be classified into one of six risk categories:
CII, Investment Principles and Risk, 2018, D Darby, J Vessey, C Gilchrist & J Alford
This article is for guidance only and should not be construed as advice. For advice in this area please speak to a professional financial adviser