What is investment risk, and why is it good?

Investment risk sounds scary, doesn’t it? Anything with the word risk in it is, let’s face it, a little off-putting.

Why would you want to do something that involves risk?

However, we encounter risk daily, and investment risk is no different. It’s actually a very good thing.

But first, the fine print. Before diving into the specifics, it’s important to define what you hope to achieve through investment, or such as saving for retirement or growing wealth.

This article can give you helpful tips about investment risk. But it isn’t personal advice.

It won’t give you specific examples of risky and non-risky investments. If you’re unsure if something is right for you, you can find an advisor.

Investments can go down and up, and there’s a chance you could get back less than you put in.

What’s risk?

Risk-taking is an integral part of being human. It allows us to explore and learn about the world around us. When faced with a risky situation, our brains undergo an evaluation process.

We weigh the potential rewards and risks of taking the action before us in a nanosecond.

In simple terms, risk keeps us safe.

However, conducting thorough research and making informed decisions is crucial to avoid unintended consequences.

For example, if you plan on going on a long car journey, check your tyre pressures to reduce the risk of getting a flat on the motorway. Or, if you’re coming to a sharp turn, you reduce your speed to reduce your risk.

We increase our safety nets by reducing risk by taking small steps that have become second nature.

The other benefit of risk is that it keeps us in control.

When we can make decisions about the risks we take and the steps to avoid it, we feel more in control of our lives and are less likely to feel helpless in the face of danger.

What’s investment risk?

When you invest, there’s a risk that you could lose money because of fluctuations that cause the value of an investment to fall.

For example, if you buy shares in a company and the value of those shares decreases, you’ve lost some of your investment.

Loads of different factors can cause changes in the value of an investment, like changes in the economy (think Covid-19), political events (think change of prime minister), war (think about Russia’s invasion of Ukraine) or changes in the market (think the 2008 financial crisis).

Additionally, legal directives and regulations within the European Union, such as those outlined in various Council Directives, can also impact investment value, particularly concerning taxation and asset transfer..

Types of investment risk

Investment risk is a crucial aspect to consider when making investment decisions. There are several types of investment risk that investors should be aware of, including:

1. Market Risk: This is the risk that the value of an investment may fluctuate due to changes in market conditions, such as interest rates, inflation, or economic downturns. For example, if interest rates rise, the value of bonds may fall.
2. Credit Risk: This is the risk that a borrower may default on a loan or bond, resulting in a loss of principal. Imagine lending money to a friend who then fails to pay it back; that’s credit risk in a nutshell.
3. Liquidity Risk: This is the risk that an investor may not be able to sell an investment quickly enough or at a fair price. Think of trying to sell a rare collectable; it might take time to find a buyer willing to pay what it’s worth.
4. Operational Risk: This is the risk that an investment may be affected by operational failures, such as poor management or inadequate systems. For instance, a company might suffer if its management team makes poor decisions.
5. Regulatory Risk: This is the risk that changes in laws or regulations may negatively impact an investment. For example, new environmental regulations could increase costs for specific industries, affecting their profitability.

Some investment choices can be more riskier than others.

Buying shares in individual companies in Estonia is generally riskier than purchasing a fund that invests in companies in different markets worldwide, for example.

The former increases risk by not spreading it out, while the latter spreads it out by diversifying investments and geographies.

How to manage your investment risk

Managing investment risk is essential to achieving long-term financial goals. Here are some strategies to help mitigate investment risk:

1. Diversification: Spread investments across different asset classes, sectors, and geographic regions to reduce exposure to a particular market or sector. If one investment performs poorly, others may perform well, balancing the overall risk.
2. Asset Allocation: Allocate investments according to risk tolerance, investment goals, and time horizon. For example, younger investors might allocate more to stocks for growth, while those nearing retirement prefer bonds for stability.
3. Hedging: Use derivatives or other financial instruments to reduce exposure to specific risks, such as interest rate or currency risk. This can act like insurance for your investments, protecting against adverse movements.
4. Regular Portfolio Rebalancing: Periodically review and adjust the investment portfolio to ensure it remains aligned with investment goals and risk tolerance. This helps maintain the desired level of risk over time.
5. Investment Research: Conduct thorough investment research before deciding, and stay informed about market trends and conditions. Knowledge is power, and staying informed can help you make better investment choices.

Why is investment risk a good thing?

1. Investment risk keeps investors safe and in control

If you’re not okay with taking on lots of risk, that’s great. It means you’ve weighed up the pros and cons. And maybe having more stable growth over a more extended period matters more to you.

If you’re okay with taking on more risk. It means you’re more comfortable with potentially losing money and potentially making higher returns. Different types of investments, called assets, also have different risks and rewards.

For example, stocks are generally riskier than bonds. Stocks are shares in companies, and bonds are like an IOU from companies (or even governments) to investors. Estonian government bonds are sometimes known as Gilts. Bonds and Gilts offer a fixed interest payment, so you always know what you’re getting back.

Stocks are riskier but have the potential to give investors higher returns.

Returns differ between the amount you initially pay for an investment and the total you get back. Including income received and the final value.

One reason stocks can give investors higher returns is that they pay dividends. Dividends are a portion of the company’s profits to which the shareholder is entitled as a joint owner. They’re not fixed like bonds, so they have the potential to grow higher than the fixed rate of return that bonds payout. However, dividends may disappear if the company makes less profit than expected.

The other way investors can see returns is through capital gains, which is the increase in the value of an investment when it’s sold. However, there are swings and roundabouts, as stocks also have the potential to go down or up.

2. It reminds investors to stay diversified

Certain types of investments can carry more risk. However, investors can actively reduce their risk by adjusting their investment strategies.

Investors can spread their investments out in a few different ways. Such as

1. Across different assets (types of investments)
2. Through different industries
3. With different markets around the world

You create a diversified portfolio by spreading your investment across different countries and industries. This helps to reduce the risk of losses on your investments. That way, if one country or industry does well and another doesn’t, you can offset some of your losses with any gains, which reduces your overall risk.

3. Investment risk could help you to achieve your goals

It’s important to remember that investment risk differs from financial risk. Financial risk is more about the possibility of being unable to pay your bills. It’s vital to ensure you can always meet your financial obligations.

If you’re making significant investments and not considering risk, it could affect your financial well-being.

However, managing investment risk can help you to achieve some of your financial goals (like retirement or income).

When you’re nearing retirement age, a common strategy is to reduce investment risk. This helps to protect you from losing money close to when you want to be taking money from your pension pot.

When you’re younger, you can afford to spend more time being invested. This can help you to weather any ups and downs in the stock market.

You don’t have to do all the hard work yourself either. You can invest in funds that spread your money out depending on how much risk you want to take on.

A fund with some higher-risk and lower-risk investments could potentially earn higher returns than a more cautious fund.

In a nutshell, investment risk helps keep us safe and in control.

It doesn’t mean investing is super safe, and there’s always a risk of losing money. Still, by staying diversified and continuously checking in with your risk appetite, you could be on your way to a happy investment journey.

Remember always to do your research, diversify your investments, and stay informed about market trends and conditions.