Managing investment risk

In simple terms, investment risk is the potential for the return on an investment to be less than you expected – this encompasses losing all or some of your original capital, as well as making less profit than expected.

Different investments are exposed to different types of risks, with the more common including:

• Market: also known as systemic risk, market risk is unavoidable when investing. It affects all securities in the same way, and can’t be fully diversified away
• Business: the possibility that the issuer of a security will lose value or go bankrupt
• Credit: the possibility that a bond issuer will default on their coupon payments and principal repayment at maturity
• Liquidity: the possibility that you will not be able to sell an investment quickly, for example when there is little or no demand to buy the asset you own
• Inflation: the potential for the value of your investment to be eroded, as inflation reduces the value of capital or income payments

The above is not a comprehensive summary of all potential risks involved in an investment, and it's important to investigate the potential risks involved in any asset before you make an investment decision.

When thinking about investing, it's natural to consider the potential downsides; many new investors instinctively view risk as negative, and something to be avoided. While it is prudent to protect yourself, it's also important to understand the relationship between the risk you choose to take on, and the returns you may potentially make.

At a basic level, the relationship between risk and reward is direct: the more risk you take, the higher your potential return. This is because the market is compensating you – through the potential for higher returns – for taking on the risk of your investment losing value.

It's important to be clear that higher risk does not necessarily equal higher returns; instead, higher risk gives you the possibility of higher returns. Nothing is guaranteed, so this means higher risk also carries a higher potential for losses.

In order to earn a return on investing, you must take on risk. Savvy investors look to strike a comfortable balance between risk and the returns they are looking to achieve, managing their portfolio in a way that minimises the chance their portfolio will lose value. Some ways you can manage investment risk within your portfolio:

• Diversify: by investing across a range of asset classes, industries and geographies, you reduce the impact that negative performance of a single investment can have on the overall value of your portfolio
• Invest for years, not months: investment markets can be volatile, but over time both bond and equity markets have generally provided positive long-term returns. If you invest with a long time horizon, you should be able to ride out any short-term fluctuations in portfolio value.
• Review regularly: it may seem intuitive, but keeping an eye on your investment portfolio is an important risk management tool. In order to maintain a balanced portfolio, you may need to periodically sell asset classes that now take up too much of your portfolio, replacing them with assets that are now under-represented.

If you are unsure of how to best structure your investment portfolio, and manage investment risk, you could look to a professional adviser for guidance on an appropriate asset allocation.