What is... | November 24, 2010

What is financial risk?

Investors can benefit from understanding different types of investments - and the financial risks involved. People take risks every day, whether in deciding to cross the road or choosing to take a train rather than drive. Few of us make a detailed risk assessment each time.


Financial decisions also involve risk. Buying shares, putting money aside for a pension or choosing to keep all your money in a bank involves deciding how much risk you want to take on in your personal finances.

Risky business
Many people think about risk as a negative outcome - that their investment may be worth less in the future. An example is the mandatory warning on investment products in the United Kingdom that their value may "go down as well as up". However, risk can also have positive outcomes as there is a chance earnings on riskier investments can be higher than on those at the safer end of the risk spectrum. Despite talk about "risk-free investments", in reality few products can be correctly described as having absolutely no potential negative risks. Even cash held at a bank - considered a low-risk option - can be at risk if the bank fails and government guarantees do not cover the total amount deposited. The video tutorial What are the basic investment products available? details the return and risk characteristics of cash, bonds, funds and shares.

How much risk can I take?
How much risk an investor should take depends in part on their attitude to risk and their stage in life. Some may be willing to take a lot of risk (or have the financial resources to sustain potential losses of investing in high-risk products), while others may not be as tolerant. As a general rule, someone who is young and single can typically take more investment risk than someone who is elderly. Under the theory of the lifecycle approach to investing, the young person has more time to recover losses. This is why financial advisers talk of some investments being "not suitable for widows and orphans". The eZonomics video The lifecycle approach to investing explains the basics of this approach to managing financial risk.

Pricing the risk
There is a link between the amount of risk people are prepared to take and the rewards they can expect to make. This risk/return relationship is important as it guides investors towards the types of products to buy. People looking for a "guaranteed return" may buy individual bonds and hold them to maturity - but this could produce a low return. Investors looking for higher returns will tend to buy products such as emerging market equity funds, individual shares, property or even adventurous assets such as art, jewellery and wine, if they have an intimate knowledge of them.

Safe as houses?
While thinking about the relationship between risk and return, investors should remember that there is no such thing as a totally risk-free investment. At the extreme, although a pile of notes and coins under a bed would not go down, inflation would reduce its purchasing power. The Measuring Worth website shows how several currencies lost value over time due to inflation. Government bonds are seen as "safe havens" for investors in times of trouble but returns can be affected by inflation, interest rates and possible defaults. The phrase "safe as houses" may be a commonplace English saying but it is definitely not economically correct. Property prices can rise sharply but they can also fall dramatically as homeowners in some parts of the world saw over the last three years. An interactive graphic on The Economist details ups and downs in house prices in 20 economies. Investors can benefit from understanding different types of investments and the financial risks involved.

InvestingRisk

Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics

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