Risk

Risk is complicated and personal to you. Do not be afraid to question what your advisers mean by it.


Why does it matter?

Because you get rewarded with higher returns for taking on more risk. It is as bad to take too few risks as too many. See Risk Premiums later.

Risk is....

...... multi-dimensional. It could be:

  • Inflation risk - the risk that your money will not buy what you thought it would.
  • Income risk - the risk that your investment income will change.
  • Default risk (or capital risk) - the chance that you will fail to get back all or part of your capital.
  • Counterparty risk - the chance that the person or body (the 'counterparty') on the other side of your investment will fail to deliver on his promise to you.
  • Liquidity risk - the chance that you will be unable to sell your investment when you thought at the price you expected.
  • Ownership risk - the chance that someone else has rights to what you thought was yours.
  • Flexibility risk - the inability to adapt your investment to new circumstances.

Each dimension is to some extent measurable. You can have high or low inflation, high or low default risk, you can be locked into investments for a short or long time.

Each dimension has a time factor. The risk of something happening within a given period will depend on the length of that period. Some risks decrease with time - risk of total returns falling below a threshhold, for example (you'll have to trust us on this).

Each dimension has high or low importance for you - depending on your circumstances, your plans and your risk tolerance. Only you can decide whether an investment is more or less risky for you compared to other uses of your money.

A word on volatility

In technical investment circles the word 'risk' has come to have a precise meaning - namely 'volatility', or 'the tendency of things to swing about'. There are good reasons for this - in fact it has been an enormously productive insight that has spawned much research, heavy mathematics and opportunities for new financial products. But this is, as we have seen, only half the story .... less than half.

Don't panic!

If this sounds more complicated than you thought, it is supposed to be. It is to warn you against statements about risk in investment literature which can:

  • be over-simple (what does 'reducing risk' actually mean?)
  • claim more than they can deliver (......will reduce risk....)
  • ignore the personal side

Luckily, savers have a standard weapon to attack most forms of risk: diversification . Use it!

A teaser to finish

Since 1869, the stock market has out-performed the returns from cash in over 97% of rolling 10-year periods. So, for you, are equities riskier than cash? (Hint: there is no right answer)

 

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