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What are the risks of investing?

There's a chance you might get back less than you put in

Investing means that the value of your stocks and shares ISA (or other investment) will go up and down depending on how well the underlying stock markets are doing:

  • If the stock markets go up then so will the value of your investment
  • but if the stock markets crash, then the value of your investment could fall significantly

So if you're in the unfortunate position of needing to cash in your stocks and shares ISA just after a crash, then you could get back less than you put in.

This is very different to a cash ISA where you are guaranteed to at least get your money back with some interest.

So why would anyone invest in a stocks and shares ISA?

Usually, over the longer term, the returns on a stocks and shares ISA are significantly higher than the rate of interest on a cash ISA. This is a well recognised effect called the "risk premium" (because it's the investor's compensation for taking some risk).

Opinions vary on how much the average risk premium is, but when big financial services companies are doing calculations for their own purposes they tend to assume it will be around 3.5% on top of the rate they can earn on cash.

This might not sound very much, but if a cash ISA will earn 1.5% then it means that the most likely returns on a stocks and shares ISA are 2-3 times higher. Over 10 years, that's worth around £4,000 on a £10,000 investment.

Our comparison tables calculate most likely returns allowing for the risk premium, and also include good case and bad case returns to give an indication of how risky different ISAs are. Our risk explorer can also help you work out how whether a stocks and shares ISA is right for you.

What sorts of risks could mean you lose money?

There are lots of factors affecting the performance of investments. The financial services industry tends to categorise them along the following lines (note that many factors are interrelated and some of the categories overlap):

Systemic risks

Systemic risks are types of risks which affect almost all types of investment in the same way. For example, the 2008 global financial crisis resulted in almost all types of investment falling in value.

Systemic risks are particularly important because they cannot be eliminated by diversification. This means:

  1. they are impossible to avoid (unless you just don't invest in the first place)
  2. if you take these types of risk you will usually rewarded with higher returns (because of the "risk premium" as described above)

For this reason, the extent to which particular sources of risk are systemic or not is a key question in selecting portfolios of investments. The aim is to avoid any unnecessary (non-systemic) risk by creating portfolios which are as diversified as possible. This leaves only the (unavoidable) systemic risk, which you should be rewarded for taking via the risk premium.

All portfolios in our comparison tables are optimised for diversification using our powerful mathematical algorithms.

Non-systemic risks

Non-systemic risks are types of risks which affect just one company or just a small segment of the market.

For example, the share price of BP crashed nearly 20% following the 2010 oil spill in the Gulf of Mexico. This affected BP (and, to a lesser extent, others in the oil sector) but did not have systemic repercussions for global markets.

Non-systemic risks can be largely avoided by creating portfolios which are as diversified as possible so as not to put too many eggs in one basket. This means you don't earn a risk premium for non-systemic risk, so it is best avoided.

All portfolios in our comparison tables are optimised for diversification to minimise non-systemic risk as far as possible.

Liquidity risks

Liquidity risk is the possibility that the market will "dry up" for a particular type of investment meaning it effectively cannot be sold (other than at an unacceptably high loss).

For example, this happened to a number of UK commercial property funds during 2007 and 2008. There were so many more sellers than buyers for commercial property that many funds imposed exit restrictions on investors to prohibit them from cashing in their investments.

Our algorithms and comparison tables take liquidity risks into account.

Exchange rate risk

Exchange rate risk is the possibility that an investment in a foreign company drops in value due to country's currency falling dramatically.

For example, in 2008 the Icelandic Krona fell in value by over 35%. This meant that the value to UK investors of investments in Icelandic companies also fell.

Our algorithms and comparison tables take exchange rate risks into account.

Inflation Risk

Inflation risk is the possibility that the rate of inflation will significantly exceed the rate of return on your investment. This would mean that the cost of living has increased so much that you have lost out overall, even though your investment has performed well in £ terms.

Generally this risk is seen as applying more to cash ISAs than to stocks and shares isas. This is because historically investing in the stock market usually keeps pace with inflation better than savings rates.

Our algorithms and comparison tables do not take inflation risk into account. We could allow for inflation risk by simply re-expressing all projections and targets in real terms rather than actual £ amounts, but this would make everything harder to understand. For this particular risk, we think keeping it simple is most important.

However, it is a genuine risk that you should be aware of. For example, through the 1970's the US stock market grew on average by around 6% pa. This sounds ok until you discover inflation over the period was around 7%, meaning investors were actually around 1% pa worse off.

Interest rate risk

Interest rate risk is the possibility that government and corporate bond type investments (which are traditionally seen as relatively low risk) will fall in value due to a sustained increase in interest rates.

For example, in 1994 UK interest rates rose by around 1% and the market expected this rise sustain for the long term. The value of many bonds fell by around 5% as a result.

Our algorithms and comparison tables take interest rate risks into account.

Credit Risk

Credit risk is the possibility that government or corporate bond type investments (which are traditionally seen as relatively low risk) will fall in value due to the organisation that issued the bond either becoming more likely go go bankrupt or (less commonly) actually going bankrupt.

For example, when Lehman Brothers declared bankruptcy in 2008 the value of the corporate bonds they had issued dropped by over 90%.

Our algorithms and comparison tables take credit risks into account.

Social, political and legislative risk

Social, political and legislative risk is a broad category of risk meaning the possibility of investments falling in value due to a sovereign power "changing the rules" in some way.

This could be anything from the relatively benign (eg changes such as the rate of corporation tax) to a national revolution (creating a breakdown of property rights and mass repossession of assets).

Our algorithms and comparison tables take social, political and legislative risks into account.

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