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Managing my investments
Managing my investments

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3.1.1 Knowing the risks

You now turn to investment risks. Let’s start by hearing Anthony Nutt’s views on investment planning and managing the risks involved. Investment risk is the likelihood that the actual return from an investment will not turn out as expected. There are two dimensions to risk: amount and timing.

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In summary, risk is the chance that the actual return from an investment will:

  • be more or less than expected. This is known as capital risk and, if part or all of the return is in the form of income, income risk.
  • not be available when expected. This is an aspect of liquidity risk.

Capital risk, income risk and liquidity risk can therefore be viewed as the key ‘high-level’ risks affecting investments.

Note the assumption that risk is symmetrical: the probability of a gain is equal to the probability of a loss. Although investors typically want to avoid the downside risks of a lower return, they do want exposure to the chance (risk) of a higher return. You will follow the normal convention of describing different types of risk in terms of the bad outcomes that may result, but you should bear in mind that the risk–return trade-off means that the reward for running the risk of bad outcomes is the chance of superior returns.

Table 3.1 presents a summary of the ‘high-level’ and the ‘underlying’ investment risks that sit underneath these key risks.

Table 3.1
High-level investment risks
Capital risk The risk of loss of some or all of the original capital invested and returns made to date
Income risk The risk that the income earned from an investment is lower than expected by the investor when the investment was made
Currency risk Where an investment is denominated in a foreign currency, unexpected changes in the exchange rate may cause the sterling (or other home currency) value of the holding to be less than expected. Similarly, this can be a risk when a person borrows in one currency to purchase an investment or other asset in another currency (for example, borrowing in euros to buy a home in the UK).
Liquidity risk The risk of being unable to sell or cash in an investment or being only able to cash it in at a prohibitively low price
Underlying investment risks
Counterparty risk The risk that an entity responsible for payments to an investor fails to meet its contractual obligations – for example by failing to pay interest when it is due
Default risk The risk that the entity invested in becomes insolvent and fails to return the sum invested
Inflation risk The risk that the return from an investment is reduced in real terms due to an unexpected rise in prices
Interest-rate risk The risk of making an investment choice on a view of future interest rate movements that turns out to be incorrect
Shortfall risk The risk that a pre-defined target return from an investment fails to be met

These risks are, of course, interrelated. Can you identify some of these interrelationships?