Investing is all about the balance between risk and reward. Whilst it is easy to focus on the potential rewards from an investment, you must never forget the risk – or the potential for losing your money permanently. In general, the higher the risk of loss involved in an investment, the higher the returns must be to compensate you for that risk.
By using our handy diagram below you can compare the levels of risk and reward of investing in different markets and types of investments. In order to control risk, it is important to spread your risk or ‘diversify’ by having a range of investments. Our tracker funds follow indices which are made up of a variety of underlying investments. This means that you will not lose all of your money if one company or element of the index fails.
Lower risk investments
Cash Ultimately the safest investment is cash. From 1 January 2016 the first £75,000 you have in a bank account with a regulated, authorised bank is guaranteed by the Financial Services Compensation Scheme. This £75,000 is a risk-free investment, at least before we adjust for inflation, but the problem with cash is that the risks may be low but the returns are too. The Bank of England base rate is 0.5% and that is your benchmark, a ‘risk-free’ annual rate of return.
Government bonds The next least risky option is developed market Government bonds. There are two broad types - domestic bonds are issued by the British Government and overseas by other countries to fund themselves, for example America, Germany or Japan. The advantage of domestic bonds is that you do not have to worry about currency movements.
You can also buy what are known as index-linked bonds, whose coupon will automatically adjust to reflect inflation. If inflation rises so the does the coupon, which can be a nice degree of protection, although the coupon can fall too in the event of deflation.
The UK Government offers three different maturities; short (0 to five years), medium (6 to 15 years and long (15+ years). In each case, the longer the maturity, the higher the coupon the bond may have to pay to entice buyers, as the increased time horizon means there is a greater chance of something going wrong.
Government bonds are usually low-risk, relatively low-return instruments but they are not risk-free. Note that during the life of a bond its price will usually fall if interest rates rise (as investors sell, older bonds with lower coupons and buy newer ones which come out with higher coupons that reflect the general increase in borrowing costs). Bond tracker funds could therefore be similarly affected and any price falls may offset the benefits of the coupons paid.
Medium risk investments
Corporate bonds The next asset class in order of riskiness is good quality company – or corporate – debt. It can be bought and sold through tradeable securities known as bonds. A bond will usually be issued at a set price and repaid at that price, along with the interest payments in between, so you know exactly what you are getting in advance, assuming all goes to plan.
Companies borrow all the time without any undue incident but they are still more likely to go bust than Governments, even if the chances of it happening are relatively slim. Their bonds tend therefore to come with higher coupons to reflect this, but again the risks are higher too.
Good quality corporate bonds are generally riskier than developed market, Government ones and may be roughly on a par with better quality emerging market Government debt in terms of their risk profile.
As with Government debt, you can choose different maturities of corporate bonds, short, medium or long – and the greater the life of the bond, the greater the chance something could go wrong, and the higher the risk.
You can also focus just on British firms or look to buy the bonds of companies from developed, Western Markets.
High risk investments
Stocks and shares Stocks and shares, also sometimes known as ‘equities’, are higher risk than bonds. This is because in the event a company goes broke, bondholders are higher up the pecking order of creditors and may get a portion of their investment back. By contrast, shareholders are at the very bottom of the pile and are likely to get nothing back, in the event a firm goes belly-up.
Shares are therefore higher risk but they can offer higher returns. With a share, you can see their value rise and also get dividends if everything goes well - and over the very long-term history shows shares do provide premium returns to bonds.
Yet things can and do go wrong. Share prices can be volatile and fall hard and fast at times, while dividends be cut or even passed altogether. To use the old, well-known phrase the value of share investments can go down as well as up and the best returns have generally come through being a patient holder for a long period of time, rather than trying to trade the stock markets and duck in and out.
In general terms, there are two types of stock market,
Developed markets such as the UK, USA, Western Europe and Japan are in theory the least risky. Governments and currencies should be relatively stable and their financial markets are well developed - there should be a well-developed corporate governance regime, designed to protect shareholders and ensure companies work to the benefit of their investors. However, economic growth is relatively slow as they are relatively mature nations.
Emerging markets such as those of Eastern Europe, South-East Asia and Latin America offer greater growth potential, as their economies are less well developed. However, they can bring greater risk, as governments may be less stable, their economies more volatile and the local companies less concerned about shareholder rights.
This isn’t a perfect system and it is not meant to be prescriptive but it shows how you can quickly and easily judge for yourself whether risk and reward are in suitable balance and whether an asset class is therefore appropriate for your portfolio in answer to those four vital, initial questions on your overall goal, time horizon, target return and appetite for risk.