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Understanding Investment Risk and Ways to Mitigate It

Investing in the UK's complex and vibrant financial markets can be both exhilarating and challenging. While opportunities abound, the risks are real and multifaceted. In this post, we'll explore what investment risk means in the context of the UK markets, with tangible examples and insights into how you can manage and mitigate these risks.


Types of Investment Risk and UK Specific Examples


felame climber, indoor wall climbing

Market Risk

Market risk refers to the uncertainty that comes with changes in the overall financial market. Think of it like the weather of the investment world; it's something that can affect everyone, no matter what specific investments they hold. In the UK, a prime example of market risk occurred with the Brexit vote.


When the country voted to leave the European Union, it sent shockwaves through the financial world. No one was quite sure what would happen next, and that uncertainty made the UK's stock market very volatile, with prices swinging up and down wildly. Many investors, even those who had nothing to do with the companies directly impacted by Brexit, found their investments affected by these broader market changes.


It was a vivid reminder that even when you think you have everything under control, the overall market can still surprise you, and not always in a good way. Understanding market risk and having strategies to deal with it is a vital part of investing, especially in a complex and interconnected market like the UK's. It's about being prepared for the unexpected twists and turns that the financial markets can throw at you.



Credit Risk

When you lend money, whether it's to a friend or by investing in a company's bonds, you're taking a chance that you might not get paid back. This is what's known as credit risk. In the UK, one type of investment that involves lending money is buying bonds, such as government bonds (gilts) or corporate bonds. Government bonds are typically considered very safe, like lending money to a responsible friend who always pays back on time. But with corporate bonds, the risk can vary depending on the company.


A striking example of credit risk in action was the collapse of Carillion, a significant construction firm in the UK. Many investors bought bonds issued by Carillion, effectively lending them money. These investors were expecting regular interest payments and eventually the return of the amount they lent. But when Carillion went under, those promises went unfulfilled. The bondholders, even those who thought they were making a safe investment, faced substantial losses.


This incident with Carillion serves as a reminder that credit risk isn't just a theoretical concept; it can have real and painful consequences. It emphasizes the importance of evaluating the risk associated with any bonds or other credit-related investments and understanding that, while the rewards might be attractive, the potential for loss is always present, especially when dealing with corporate entities that may not be as secure as government institutions. It's a careful balancing act that requires due diligence and sometimes, a willingness to accept lower returns for the safety of your investment.


Liquidity Risk

Imagine you have a rare collectible item. It might be valuable, but if you suddenly need cash and try to sell it quickly, you might not get as much money as you hoped. This is an example of liquidity risk, and it's something that can happen with certain types of investments too.


In the financial world, liquidity refers to how easily you can sell an asset without affecting its price. Some investments can be sold almost instantly without changing the price much, like popular stocks or government bonds. Others can be more challenging to sell quickly without reducing the price, especially if they are not widely traded.


A good example of liquidity risk comes from the AIM-listed shares in the UK. AIM stands for Alternative Investment Market, and it's a submarket of the London Stock Exchange where smaller and often newer companies are listed. These shares can be less liquid, meaning they might be harder to sell quickly at the market price.


Why does this matter? Let's say you've invested in an AIM-listed company, and news breaks that makes you want to sell right away. Because fewer people trade these shares, you might have to lower your price to find a buyer quickly. Or you might not find a buyer at all for a while, which can be stressful if you need the money right away.


Liquidity risk doesn't mean that AIM-listed or other less liquid investments are bad; they might offer great opportunities for profit. But it does mean you need to think about how quickly you might need to sell and how that could affect your investment. Like that rare collectible, something less liquid might be an excellent investment for the long term, but it could pose challenges if your plans or needs change suddenly. It's another aspect to consider as you decide where to put your money, balancing the potential for gain with the flexibility and security you need.


Operational Risk

Picture this: you're running a well-oiled machine, everything is going smoothly, and then suddenly, a cog falls out of place. The whole system grinds to a halt. In the world of finance, that misplaced cog could be a failure in internal processes, systems, or human errors, and the consequences can be far-reaching.


Operational risk refers to the risks that are not directly tied to the market or the economy but are linked to the internal failures of an organisation. It can include anything from a software glitch to a human error, a process failing to a breakdown in routine communications. These risks might not be as headline-grabbing as market crashes or corporate scandals, but they can be just as damaging.


A prime example of operational risk occurred in 2012 when a significant technical glitch at the London Stock Exchange caused a delay in trading for several hours. Now, think about what happens in just one hour on a major global stock exchange. Trades worth billions of pounds can be made or lost. The delay caused by the glitch affected not just the day's trading but had cascading effects on investors and traders.


For traders who make decisions in fractions of a second, a delay of hours is an eternity. The inability to execute trades, particularly in a volatile market, can lead to substantial financial losses. Meanwhile, investors might miss opportunities to buy or sell shares at an optimal price.


For the London Stock Exchange itself, the glitch posed reputational risks. Trust in a trading platform is paramount; glitches like these can undermine that trust and take time to rebuild.

But operational risk isn't confined to big stock exchanges. It can affect individual investors too. Imagine if your online trading platform crashed on the day you were planning to sell a significant holding, or if a clerical error at your bank delayed a crucial transaction.


Mitigating operational risk involves robust internal processes, regular auditing, and continual updates to technology and training. The key is not only to have back-up systems in place but to ensure that those systems are themselves resilient and regularly tested.


In the end, operational risk reminds us that finance isn't just about numbers, trends, and economic factors. It's a human-made system, and like all systems, it can break down. Recognising and planning for those potential breakdowns is crucial for anyone involved in trading or investing, whether you're running a major stock exchange or just managing your portfolio.


Inflation Risk

Imagine you've stored a sum of money in a jar, planning to use it for a special purchase in a few years. Over time, the prices of things you want to buy, like a new car or a dream vacation, keep going up. When you finally open the jar, you find that your money doesn't stretch as far as you thought it would. That's a simple way to understand inflation risk, and it's something that can affect your investments, too.


Inflation is the rate at which the general level of prices for goods and services rises, eroding purchasing power. If your investments are growing at 2% per year, but inflation is 3%, you're actually losing real value, even if the number in your account is getting bigger.


A real-world example of this can be seen with fixed-income investments like savings accounts or government bonds in the UK. These often provide a fixed interest rate, so if inflation rises significantly, the real value of your returns might decrease.


Here's how it works: Let's say you have a savings account offering 1% interest, but inflation is running at 2%. Even though you're earning interest, the actual buying power of your money is shrinking by 1% each year. Over time, that can add up and make a noticeable difference in what you can afford.


In the UK, where the inflation rate has seen fluctuations, this risk becomes particularly relevant. If you had invested in a fixed-income product during a period of low inflation, a sudden spike in inflation could quickly erode the real value of your returns.


Inflation risk doesn't mean that fixed-income investments are bad choices. For many people, they're an essential part of a diversified portfolio, providing regular income and a cushion against more volatile investments. But it does mean you need to think about how inflation might affect your money over time, especially if you're relying on fixed returns for long-term goals.



Understanding inflation risk helps you make more informed decisions about where to invest and how to balance your portfolio, considering not just what returns you might earn but how inflation might reduce the real value of those returns. Just like with the money in the jar, it's not just about the amount you have but what it can really buy for you in the future.


Mitigating Investment Risk in the UK Markets


Diversification

By spreading your investments across different asset classes and sectors within the UK, such as FTSE 100 and FTSE 250 stocks, bonds, real estate, and commodities, you can reduce the impact of a downturn in any one area.


Regular Monitoring and Rebalancing

Keeping an eye on economic indicators like the Bank of England's interest rate decisions or GDP growth helps you stay informed. Regularly adjusting your portfolio to maintain your desired risk level is key.


Understanding Risk Tolerance

Imagine standing at the edge of a diving board, looking down into the water below. Some may relish the thrill, ready to leap without hesitation, while others may feel their stomachs turn, backing away from the edge. In the world of investing and trading, this diving board scenario is an apt metaphor for understanding your risk tolerance.


Risk tolerance is the level of risk that an investor or trader is comfortable taking on, given their financial goals, lifestyle, and personal characteristics. It's not just about how much risk you can theoretically handle but how much you're willing to endure.


group in London wit hflags and flares celebrating UK Brexit decision

In the volatile landscape of the UK financial markets, understanding your risk tolerance is a critical exercise. There are countless investment opportunities available, each with its own level of risk and reward. From the relative safety of UK government bonds to the high-octane thrill of tech stocks, the markets offer a broad spectrum of options.


But what works for one investor may not work for another, and that's where understanding your risk tolerance comes into play. Are you the type of investor who can weather significant ups and downs in your portfolio, secure in the knowledge that risks often lead to higher rewards in the long term? Or do you prefer the steady, more predictable returns of fixed-income investments, knowing that you might sacrifice higher gains for peace of mind?


The importance of aligning investment strategies with personal risk tolerance became apparent for many during events like the Brexit vote, where market volatility made for a wild ride for UK stocks. An aggressive trader focusing on high-growth sectors might have seen this as an opportunity, while a more conservative investor may have been glad to have their assets tied up in more stable, lower-yield investments.


Assessing risk tolerance isn't a one-time event. It can and should evolve with life circumstances, financial goals, and market conditions. Regularly revisiting and evaluating your risk tolerance can help you align your strategies and decisions with your true comfort level, ensuring that you're not merely chasing returns but building a portfolio that reflects who you are and what you want to achieve.


Whether you find yourself drawn to the safe shores of government bonds or the exciting waves of tech stocks, recognising and honouring your risk tolerance can lead to a more satisfying and successful investing experience. It's about finding the right diving board for you, and knowing when and how to make the leap.


Professional Guidance

UK investment professionals can offer insights specific to the local market. They can help navigate issues like Brexit-related uncertainties or regulatory changes, providing tailored strategies.


Using Hedging Strategies

Currency risk is a significant consideration for UK investors, especially post-Brexit. Utilising currency futures or options to hedge against adverse currency movements can be a prudent strategy.


Final Thought on Understanding Investment Risk

Investing in the UK's financial markets offers many opportunities, but awareness and management of the associated risks are crucial. Whether you're trading FTSE shares, investing in government bonds, or diversifying across various asset classes, a thoughtful approach to risk can help you navigate the UK's unique and dynamic market landscape.


Remember, investment risk in the UK, as elsewhere, is not something to be feared but understood and managed. Happy investing in the UK!


Disclaimer: This blog post is for informational purposes only and should not be taken as investment advice. Always consult with a qualified financial professional before making any investment decisions in the UK or elsewhere.

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