The aim of this guide is to help you to gain a better understanding of the relationship between risk, return and volatility. We’ll only be talking about investing in funds, rather than investing in specific companies. It will also offer some useful pointers to help you understand your own attitude towards risk, and hopefully help you to make better investment decisions.

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Risk should be calculated, assessed and understood

Investors tend to judge the success of their investments by the returns they make, but the return tells only half the story. Risk is as important as any other aspect of making an investment decision. In fact, it’s arguably the most important aspect. Ignoring risk when making investments can prove costly. Understanding the risk of an investment is as important as understanding the possible returns. There’s an intrinsic link between risk and return in everything that you do. Investing is no different.

Defining Risk

The concept of risk has many different definitions, but to keep things simple, it makes sense to think about investment risk in three ways:

  1. You could lose some or all of your investment

When you make an investment, you hope that it will increase in value and one day be sold for a profit. But there’s no guarantee. There is always a possibility that you end up losing part or all of your investment. Even if your investment grows in value, there’s no guarantee it will perform to your expectations. You can’t rely on an investment’s past performance to be repeated in the future.

  1. Your investment may be worth less in the future

It’s also worth remembering that inflation (the rising cost of everyday goods and services) can erode the value of an investment over time. For example, if an investment returns 1.5% every year, but annual inflation rises at 2%, the money invested will be worth less when you look to spend it. This ‘inflation risk’ has become more of a concern in recent years, as very low interest rates have reduced returns available through cash savings accounts.

  1. Your investment journey may be uncomfortable

Investments can be volatile, and the riskier the investment, the more unpredictable its return is likely to be. Alternatively, taking fewer risks should make your journey more comfortable, but could mean it takes much longer to reach your destination.

Putting risk into context

For most investors, the biggest risk they face is losing money. While the probability of losing capital can be high, especially in the case of individual stocks or shares, it may be reduced through diversification. Spreading your investments can provide greater control over a portfolio’s expected risk and return.

Risk and return go together

You can’t have a sensible discussion about investing without talking about risk. And while everyone would like their investments to deliver the best possible returns, those returns shouldn’t come at any price. If an investment promises high returns without mentioning the risks it intends to take with your money, then it’s definitely too good to be true.

Choosing higher or lower risk investments

One of the fundamental principles of investing is that higher risk investments should, in theory, lead to higher rewards. But there are no guarantees. Investments that offer the potential for higher returns also come with a greater possibility that the investment will fail to meet expectations or fall in value.

At the other end of the risk spectrum, an investment that takes as little risk as possible, such as putting your money in a cash savings account will not deliver much of a return, and this low return may not even keep up with inflation.

The amount of risk you are prepared to take is really a matter of personal choice – there’s no ‘one size fits all’ approach. Some people want to take very little risk, because their priority is to not lose money. Others are prepared to take greater risks with their money if it means the possibility of achieving much higher returns.

Finding out your own attitude towards risk is one of the first steps towards successful investing. Your financial adviser will be able to help you with this.

Volatility explained

Understanding volatility is vital when it comes to choosing the right investments. But volatility doesn’t usually get discussed in depth. Volatility is a way to calculate the risk of a particular investment, over a set period of time. A highly volatile investment is likely to experience more frequent, and possibly large, upward and downward movements in price than an investment with low volatility.

Measuring volatility

The most common way to measure volatility is through ‘standard deviation’. This measures how much the returns of an investment move away (or deviate) from its average returns. More volatile investments deviate further and more frequently from their average. Volatility is shown as a percentage, in the same way as investment returns are shown.

Managing volatility

Fund managers can use their predictions of the volatility of different sorts of investments when constructing portfolios to target certain levels of risk. This is known as ‘risk targeting’, and while it’s impossible to predict exactly what the return and volatility of an investment will be in the future, this approach makes it more likely that a portfolio of investments will perform as expected.

Volatility cannot be avoided or removed from an investment, but it can be managed to make it work to the advantage of investors.

Some key investment rules to remember

If you’re considering making an investment, it’s well worth sitting down with your financial adviser to discuss risk, return and volatility in more detail.

Know your objectives

With your financial adviser’s help, you can find the answers to the questions that will help to determine the right investment to suit you.

What are your investment goals?

Are you investing for a short-term goal (like a holiday or new kitchen) or investing for the longer-term, to help pay for your retirement? Understanding your investment timeframe and the return you need from your investment will largely determine the types of investment you should be considering.

How much risk are you prepared to accept?

Would you be comfortable if your portfolio fell in value by 5% over your investment timeframe? What if, in any one year period, it fell by 20%? Answering these questions will help you become more realistic about your personal attitude towards risk and losing money.

Diversification is important

You’ve probably heard the saying: ‘don’t put all your eggs in one basket’. In the investment world, this phrase is summed up in one word – diversification. No professional investment manager, no matter how experienced or gifted, can predict exactly which investments will perform well in any given year. So it makes sense to diversify – or spread – your money across a number of investments as broadly as possible, preferably across different assets, investment types, sectors and geographical regions.

The value of investments, and any income from them, can fall and you may get back less than you invested. Tax treatment depends on the individual circumstances of each client and may be subject to change in the future. Neither simulated nor actual past performance are reliable indicators of future performance. Information is provided only as an example and is not a recommendation to pursue a particular strategy.