What is risk?

Risk is a word often used but rarely fixed in terms of definition. At its heart, investment risk is the chance that an investment will lose money compared to either cash or a benchmark. This is often treated as identical to volatility, but this has significant shortcomings, not least of which is the fact that volatility in isolation includes periods of high growth as well as losses.

It is perhaps better to think of risk as uncertainty, in which case there are a few subdivisions to consider, including:

  • Inflation risk – the chance of an investment or holding failing to keep up with price rises.
  • Market (systemic) risk – entire markets can fall in value at once, either as a result of one of the other risks in this list (e.g. the Russian market as a result of the 2022 invasion of Ukraine) or by simply falling out of favour (e.g. Japanese equities at various times over the past few decades).
  • Credit risk – the chance associated with an individual, company or government defaulting on their loan obligations. Most obviously this would have a direct effect on the holders of that debt, but indirectly might affect more investors in the wider market.
  • Mortality/morbidity risk – if a key individual for the investment falls ill or dies, the business may well fail. In specific cases such as life settlements funds, this risk may also extend to the cohort of business investments, so the risk may actually be that people live too long rather than dying early.
  • Individual holding (non-systemic) risk – an individual investment entity can either be mismanaged or could just fail regardless. This can even happen to very large companies, e.g. Enron.
  • Political risk – the actions of governments can have significant impact on investments, for example wars. In addition, sovereign governments tend to reserve the power to affect their monetary and fiscal policies through the setting of central interest rates and the tax codes which apply to investors and employees.

In general, the goal of sensible investing should be to minimise as many of these risks as possible through an appropriate level of diversification. In addition to the above, it is worth considering risk in two distinct categories:

  • Capital risk – arguably this is closely linked to volatility measures, as it refers to the price that could be achieved by selling the investment.
  • Income risk – if an investor is reliant on their income but has no reason to spend capital (e.g. retirement funding) then it is much more important for them to look at security of income than preservation of capital value.

When it comes to risk, this is specifically divided into three categories by the Financial Conduct Authority:

  • Risk tolerance – how much risk an investor is willing to experience.
  • Capacity for loss – a mathematical expression of how much risk an investor can afford to take, usually calculated using some form of cash flow forecasting. This category also accounts for the need to take some form of investment risk to achieve their goals.
  • Knowledge and experience – investors with significant knowledge and experience may have sufficient education on investments to deviate from the normal risk profiling exercise.