Whether your money is invested in funds, on deposit at the bank, or squirreled away under the mattress, you’re faced with investment risk.
Here, we outline four main kinds of risk your money faces, and what you can do about it.
What is investment risk?
As we’ve heard many times, investing involves risk: your investment can go down as well as up in value.
But it’s not the same as playing the lottery. Investment risk in this context is simply a way of describing what kinds of ups and downs you are willing to put up with in order to give your money the best opportunities to grow.
1. Inflation risk
This is the risk that the value of your money will reduce due to rising prices. It’s the main risk of holding all your savings in cash. When prices go up over time, and your money fails to keep pace, you are getting poorer.
Of course, by keeping your savings in the bank – or under the bed – the amount of money you have won’t go down, even if inflation means it buys you less.
2. Capital risk
On the other side of the risk spectrum, capital risk describes the situation where you can lose some or all of your money, for example by investing in an asset which falls in value. Company shares and investment funds carry capital risk.
Capital risk really matters if you’re forced to sell your investment, and crystallise the loss. If you can afford to wait, sitting on a ‘paper loss’ is an option while you wait for your investment to recover in value.
For example, investors in the FTSE100 at the start of 2018 would have lost money if they sold in March, but by May would have been in profitable territory once more.
In finance, risk and return are connected. So in order to give your money the chance of generating a return, you’ll probably have to bear some capital risk.
3. Company risk
This is the risk that the business you invest in (perhaps by buying its shares) will underperform, and you will lose money as a result.
Unless you’re prepared to invest in many different companies and monitor your investments accordingly, you will bear a lot of company risk when you invest in shares. That’s one reason Moneycube prefers investment funds.
4. Liquidity risk
Liquidity risk occurs when you can’t get access to your money at a fair price when you need it. Cash is the most liquid investment of all.
In contrast, liquidity is a key investment risk if you invest in property. Liquidating a property investment will typically take six months or more if you wish to avoid a ‘fire sale’ price.
Property funds can offer some mitigation of this risk, but even they have been known to suspend payouts in unusual times. For example, after the Brexit vote a number of UK property funds stopped payouts to investors temporarily.
What’s to be done?
There is no risk-free option when it comes to your money; only different kinds of risks. The queues outside Irish banks in 2008 showed us that leaving cash in the bank can be extremely risky.
The best approach is to avoid putting all your eggs in one basket – known in the investing world as diversification – and spread the kinds of risks you’re taking.
PS: Interested to read more? Here’s Investopedia’s article on investment risk.