Generally, the degree of risk you are prepared to accept for your money will determine the return you receive from it. But here is a conundrum: who defines what is risky and what is not?
Clearly, what you or I accept is a hazardous - even foolhardy - financial strategy will be seen by another person as the quintessence of safe-as- hands money management.
It is virtually impossible to determine for everyone and evermore what is or is not an acceptable level of risk. But we can begin to discuss a few of the principles that should govern our attitude to this subject. Thereafter, we can examine some of the most common products and place them in some kind of order according to the risk they subject to cash placed with them.
The first point to understand is that theoretically, there is no investment which is 100 per cent free of risk. Moreover, the word itself is elastic and can have different meanings.
For example, one understanding of risk is where even a nice, seemingly safe building society could go belly-up, leaving you to claim compensation worth just 90 per cent of your deposit, up to a pounds 20,000 maximum. Another understanding of risk is that the interest paid on your deposit is less than inflation at that point in time.
The second point is that our willingness to accept financial risk can change according to many circumstances, including age, for instance. Younger investors can afford to take a more long-term view if equity prices fall. Older investors, particularly those close to retirement, need to protect their capital.
Third, although the safest form of investment may still be that mythical building society account, better performance has tended to come from equities.
That is not to say that share prices move up in an uninterrupted curve. Volatility, as seen by yesterday's fall in the FTSE 100 share index, will always remain with us. The key then is how to average out the cost of investing.
Take a fund in which you invest pounds 1,000 every year for 10 years. If the value of the fund increases by a set amount every year, you will show a certain return. By comparison, if you invested in a far more volatile fund, which experiences a range of ups and downs, you might feel you were likely to be investing in a loser.
Actually, that is not necessarily certain. The pounds 1,000 you invest in "bad" years will buy you more shares, units or whatever the measure of investment is. In an upturn, those "cheap" units will grow faster in relative terms and, because you have more of them, your gains will be greater.
A fourth point to consider is the effect that interest rate movements can have on the value of your capital.
Say you buy a fixed-interest security, such as a corporate bond. The bond cost pounds 100 and has an income of pounds 10, or 10 per cent of the sum invested. If interest rates were to fall to 8 per cent, the value of the investment grows. This is because the corporate bond's income, which may previously have been unexceptional, suddenly becomes more attractive. More people will want to buy it, pushing prices up.
If the income of pounds 10 is deemed to be equal to the new interest rate of 8 per cent, the bond's price may have to rise to pounds 125. This seesaw also implies risk in the market. If you invest at the wrong time, a rise in interest rates can have the opposite effect on the value of your corporate bond.
Either way, what also becomes clear is that, unless interest rate movements begin to gyrate madly, the level of risk is smaller with fixed-interest securities than with straightforward equity investments.
Which takes us to the next point about understanding risk. As our illustration at the bottom of this story shows, there are different levels of risk depending on the type of financial product one is considering.
This table is useful if you speak to an independent financial adviser who will want to recommend a product to you. But the important point to remember is that risk is not the only basis for investing. The suitability of a product is as important as the issue of whether capital erosion may take place.
One key aspect of any understanding of risk is that investments do not all present the same risks at the same time. While UK share prices have rocketed ahead in the past 18 months, Japanese equities have languished.
Investing in just one stock market might involve greater risks than necessary for little reward.
The final part of understanding risk is that it is something to savour and even enjoy in moderation. If you can afford it, take risks with some of your money, as long as you are prepared to lose the lot.
Towry Law, a firm of independent financial advisers, is offering copies of its "Principles of Investing" to readers of The Independent. Write to Towry Law, Baylis House, Stoke Poges Lane, Slough, Berks, SL1 3PB or call 0345 889933.Reuse content