Risk is a concept we all intuitively understand – whether we’re crossing a busy road, wearing a hard hat on a building site or betting on horses.

It is also something some are happier to embrace than others. Some people, for example, will happily jump out of a plane (albeit with a parachute), while others won’t even get on one.

When it comes to investing, though, risk is less a matter of common sense and instinct and more something that requires a little explaining, and perhaps some reassurance too. This is the aim of this article, because knowing what investment ‘risk’ is and how to manage it is crucial to your chances of reaching your goals and becoming a successful investor.

How to think about investment risk

Boiled down to its very essence, the risk I’m talking about is the risk of losing money.

But then this kind of risk isn’t limited to just investing. It exists even when you’re not trying to grow your money. Keep money under the mattress, for example, and its purchasing power will be eroded by inflation. It might also get stolen. Leave money in a bank account earning a pitiful rate of interest and, again, its value will be eroded by inflation.

There is no option for your money that is truly risk-free. There is always some element of risk. So, when it comes to thinking about investment risk, a good way to start is to view investing as part of a continuum that gets progressively riskier as you seek a potentially higher reward.

At that point it then becomes a question of: how much risk are you comfortable with? However, park this thought for now.

Over what period?

The second thing to consider is how investment risk isn’t a one-off event. After all, you may be invested for many years. If your investments lose value one year, they could go up in value in subsequent years. You only make an actual loss if you realise that loss by selling out of your investment. It’s a paper loss until that moment. Painful to look at, maybe, but a paper loss all the same.

It follows, therefore, that the longer you expect to be invested (because of how far away your goal is), the greater the investment risk you may be prepared to take, and vice-versa.

So, if you are in your 30s and saving for your retirement, it’s fair to say that you have more wiggle room to potentially take more risks with that money than if you are saving for a shorter-term goal such as a house deposit or wedding. This is because you theoretically have more time to ride out potential fluctuations in the value of your investments.

In sum, if we were to express investment risk as a personalised formula, it might read something like this:

My investment risk = Time to my investment goal/My stomach for risk

Measuring and managing risk

Now that we’ve discussed investment risk and how it pertains to you, the next question is: how can you best invest in a way that reflects your risk preferences?

To answer this, let’s start by considering why different types of investments are deemed to be riskier than others. In large part, this has to do with how they’ve performed in the past – the degree to which their returns have varied over many years. The bigger the spread, the higher their perceived risk. And vice versa.

Past performance is no guarantee of future performance, but it can serve as a guide.

In the main, investment grade bonds – a type of loan to governments and companies that can be bought or sold on markets and usually pay interest – have tended to be less volatile than shares. In general, they have recorded shallower losses but also more modest gains than shares, which is why investment risk is so intimately connected to the idea of investment reward.

So, by changing the proportion of bonds and shares you own, you should in theory be able to finesse the amount of risk in your portfolio. The more bonds you have, the lower the risk, and the more shares you have, the higher the risk.

This is the thinking behind our LifeStrategy range of funds but something that is also reflected in the second of our four investment principles, which is to stay balanced.

Historically, higher-return assets have brought increased risk

Best, worst and average returns for various stock/bond allocations, 1901–2021

Past performance is not a reliable indicator of future results.
Source: Vanguard.
Notes: Reflects the maximum and minimum calendar year returns, along with the average annualised return, from 1901-2019, for various stock and bond allocations, rebalanced annually. Equities are represented by the DMS UK Equity Total Return Index from 1901 to 1969; thereafter, equities are represented by the MSCI UK. Bond returns are represented by the DMS UK Bond Total Return Index from 1901 – 1985; the FTSE UK Government Index from Jan 1986 – Dec 2000 and the Bloomberg Sterling Aggregate thereafter. Returns are in sterling, with income reinvested, to 31 December 2021.

To further illustrate what we mean, consider the chart above, which shows returns in the UK stretching back some 120 years for different mixes of bonds and shares. In the squares at the top you can see the exact proportions used for each hypothetical portfolio.

The numbers at the top and bottom of each bar, meanwhile, reflect the maximum and minimum calendar-year returns over 1901-2021 and the numbers inside the bars denote the average annualised return for each portfolio over this period.

As you can see, the further right we go (and the greater the allocation to shares), the higher the potential gain and loss.

If you wanted to visualise what investment risk looked like, you’d be hard pressed to find a better chart. Equally, you’d be hard pressed to find another one that demonstrated the benefits of being balanced but also disciplined when faced with paper losses.

Don’t forget to diversify

That investing in the right mix of shares and bonds could have a bigger impact on your returns than anything else you do is something that is supported by academic research¹. It’s all about finding the level of risk and reward that is right for you.

One final word of warning: all of the above assumes that your investments are diversified – that they are spread across many different shares, bonds and markets.

This is important, because when you drill down further and look at individual bonds and shares, other types of risk can emerge. Will this company issue a profit warning or will its growth surpass expectations? Will this company benefit or be adversely affected by higher oil prices? And so on.

Risk can also vary country by country. What is the growth outlook for this or that economy? How will it be affected by this or that geopolitical event? How will the local business environment be impacted? And so on.

Being diversified is crucial when it comes to finding the level of investment risk that is most appropriate for you and managing that risk, because, as the age-old saying goes, you shouldn’t put your eggs in one basket.

It’s the big advantage investing in funds of shares and bonds has over investing in individual shares and bonds. Our LifeStrategy 60% Equity fund, for example, offers exposure to more than 40 countries and more than 27,600 unique share and bond holdings.

 

¹ A now-famous study by Brinson Hood and Beebower, published in 1986, looking at returns for 91 US pension funds from 1974 to 1983, found that roughly 80% of the variance of returns comes from strategic asset allocation. Since then a great many studies, looking at different periods and types of funds, have come to similar conclusions, including a Vanguard study based on monthly returns for 743 UK balanced funds from January 1990 through September 2015: The global case for strategic asset allocation and an examination of home bias (Scott et al., 2016).