Every investor relies on two essential concepts to determine the best course of action before deciding whether to stake their money: risk and reward.
Risk is the potential for investments to perform well against expectations or to fail, resulting in losing money.
There are many ways to quantify risk, but it’s essential to understand the fundamentals and know how to match that appraisal against your accepted exposure levels.
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Calculating Investment Risk: The Basics
The idea of risk is nothing investors are not familiar with. In investment, each individual will have a different attitude, depending on things like:
- How much capital they are investing.
- Their age and financial security.
- When they expect to draw on investment returns.
- Investment values and ethics.
Each investor has a risk profile without a right or wrong answer. This profile determines how willing they are to expose their funds to potential losses in exchange for the possibility of receiving higher returns quickly.
In essence, the bigger a risk you take as an investor, the bigger the gain might be, but there are multiple types of risk.
For example, buying equity shares in a company is a higher risk than a government bond or a National Savings and Investments product.
There is a far higher likelihood that a corporate entity will go bust than that the government will declare bankruptcy.
Investment Risk In 2022
Increasingly, investors are drawn to higher-risk products, such as crowdfunding start-ups or snapping up crypto as a short-term investment strategy.
The problem here is that new or casual investors may not have clarity about the associated risk level or how to match that against their requirements – and with around six per cent of all UK investors holding funds in high-risk products, the fall-out could be substantial.
In response, the Financial Conduct Authority (FCA) has published an article called Beyond Disclosure for High-Risk Investments to help consumers acknowledge the potential pitfalls.
Recommendations include providing red alerts on marketing pages to highlight the risk element of the product and evidence requests to prevent vulnerable users from making quick decisions that could be financially disastrous.
Around 45 per cent of crowdfunding investors are unaware that they could lose all of their money if a deal goes wrong, so it is a big issue.
The Difference Between Low-Risk And High-Risk Investments
Any investment carries an element of risk, no matter how unlikely it might seem.
There is a world of difference between a low and high-risk investment product, but that may not seem immediately obvious to new investors, as the statistics above show.
One of the challenges is that fund managers, financial advisers and wealth consultants may all have different definitions of risk, and there isn’t a universal standard everyone relies on.
The easiest way to think of it is that your investment risk is the potential that your investment will underperform.
For example, if you buy a product with a forecast ten per cent return, your risk is the potential that your return will be less than ten per cent.
Underperformance and risk can also be considered as two different things – underperforming might be that you get, say, a nine per cent return.
In contrast, the critical risk is that you receive nothing and lose your invested cash.
High-Risk Investments
If you’re considering an investment product categorised as high risk, it has been analysed as having a higher percentage chance of loss or under-performance or a much higher potential of a total loss.
Again, it’s subjective, and much depends on the assessment framework used:
- An investment with a 50/50 potential of meeting your expected profits will usually be considered a moderately high-risk option.
- If you have a 95 per cent chance that the investment will not meet expectations, it is almost certainly high risk.
However, if you are developing your risk exposure approach, you also need to be conscious of magnitude, not just the percentage likelihood of one outcome or another.
For example, look at airline safety statistics from a FlyFright report.
The chances of dying in a plane crash between 2012-16 were one in 3.37 billion, and the potential of being on a plane in a fatal accident was one in 20 million.
However, 98.6 per cent of all crashes did not result in any deaths, and of 140 accidents in the reporting period, only two experienced fatalities.
That demonstrates the nature of statistics and figures and why it’s vital to adopt a well-rounded approach to understanding the true meaning of a risk profile and whether it’s consistent with your expectations.
Low-Risk Investments
A low-risk investment means you have less to lose and less to gain – the corresponding ratio means that a safer product will inevitably return more modest profits.
Low-risk investments can be a great way to reduce the chance of making a loss and ensure that any losses you encounter won’t be disastrous.
The complexity is that investors won’t be drawn solely to low-risk investments because the gain available is significantly lower, and they usually balance their risk exposure by mixing investment products.
In a portfolio, the total risk exposure includes the risk associated with each asset or product, so you can offset high-risk in one asset class by choosing something low-risk in another.
Diversifying to Mitigate Risk
Diversification is the most common strategy to keep investment risk under control.
Investing in a range of securities and industries means that, while you aren’t guaranteed a zero-risk return, you have a more balanced exposure that aligns with your needs.
There are many different diversification approaches, so you might:
- Invest in several different vehicles, such as bonds, stocks, cash and funds. It is important to monitor ongoing performance to identify declining investments that need attention.
- Invest in one type of product, such as securities, but mix up your fund across different countries, regions, industries or sectors.
- Invest across assets with different risk profiles, so have some investments with potentially huge gains and others with a low risk to reduce your overall exposure.
Diversifying an investment portfolio isn’t a standalone project. You need to keep an eye on the balance, monitor how each asset is doing, and make adjustments where the risk level doesn’t comply with your financial strategy.
Matching Risk And Investor Expectation FAQ
Matching is an approach used in investment risk management, which looks at the expected returns on a portfolio, and the profits the investor needs to cover any potential future liabilities or planned costs.
Each investment decision is based on the investor’s unique risk profile and cash flow demands to tailor asset choices to fit their requirements.
While the notion is simple, it can become very complicated, aligning specific securities with defined investment amounts and creating maturity timelines to evaluate when each asset reaches a crystallisation event.
Calculating investment risk isn’t straightforward, although the basic idea is a positive correlation between risk and returns. In essence, the higher the risk, the higher the possible profits and the higher the potential losses.
Low-risk investments are likewise linked to low returns but low uncertainty levels.
There are many variables to deciding on your attitude to risk and numerous calculation methods used to arrive at a risk assessment.
Standard deviation is the most common, considering how volatile the investment value is. This technique uses historical averages to see how often and by how much an asset deviates from the standard expected performance.
The simplest way to think about your risk profile is to assess your certainty equivalent. This measure is the smallest value that you wouldn’t mind gambling or investing without any concern if the investment failed.
If your certainty equivalent value is lower than the calculated prediction that the investment gains will be subject to uncertainty, you are a risk-averse investor.
Most investors rely on diversification to control their risk exposure, allocating investment capital across different types of products to match their risk/return profile.
Financial advisers and wealth managers use a range of risk management strategies to analyse their client’s attitudes to risk and select appropriate products to balance their portfolios accordingly.
Standard deviation, which we’ve mentioned above, is the most common way to gauge investment risk and make an informed decision.
Some of the other approaches include an analysis of alpha and beta ratios or using other metrics provided by the fund to determine their opinion on the associated risk.
Other methods include Value at Risk calculations and the Capital Asset Pricing Model, which tries to determine whether the value of a stock is appropriate compared to expected returns, inflation and risk.
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