Spin-free Guide to Risk

Contents What exactly do we mean by risk? 3 Risk versus reward 4 Balancing risk – too much or too little? 5 Different types of investment and their level of risk 6 Find your level of risk 7 Common types of risk with investment 9 Ways to diversify and manage your risk 12 A few final reminders on risk 14 Glossary 15 Spin-free guides 16 Please refer to the glossary found on page 15 for an explanation of the words highlighted in bold throughout this guide. We are unable to give financial advice. If you are unsure about the suitability of your investment, speak to a financial adviser. The views expressed in this document should not be taken as a recommendation, advice or forecast.

What exactly do In life, risk is generally seen as something to be avoided. With investment, risk could be beneficial. A higher risk investment doesn’t mean an investment to be avoided – it simply means the we mean by outcome is less certain. risk? The level of risk you take should depend on your investment goals. If you’re investing for the long term, you may choose a higher risk investment. If you’re investing for the short term, you may choose not to take a lot of risk. Risk in a nutshell When you think about risk in life, you think about Which road you choose depends on your goals – the potential hazards or increased levels of danger. Risk traffic-free road will get you there eventually but if in finance and investment means something slightly your goal is to get there faster, you may take the direct different – it simply means the level of uncertainty in route, and take the risk of getting stuck in traffic. the outcome of your investment. Deciding your goals All investments carry a level of risk, and a higher risk Your investment goals are the first thing you need investment doesn’t mean that you should avoid it at to think about when choosing your level of risk. Your all costs. It simply means that there is less certainty in goals should depend on your individual circumstances, the outcome. attitude to risk and your stage of life. Are you investing When you make an investment, you can never be for the long term to meet a target amount, for example, absolutely certain what you’ll get back when you cash it to pay off the mortgage, save for your children’s in. Risk is implicit in all investments. To achieve a return, education or provide a decent income in retirement? you must therefore be prepared to take some form of If so, you might be prepared to take bigger risks to risk. Even so-called ‘risk-free’ assets are not completely boost returns over a longer timeframe. Alternatively, without risk. you might be saving for the short term or just be looking for a steady income – in which case, it is unlikely Assessing risk that you will want to take much capital risk. Although investment risk is more about uncertainty The reasons you’re investing, the level of risk you’re than danger, you can weigh it up in a similar way to prepared to take and when you’ll need access to your real life risk. For example, there may be two roads into money, should influence the types of investments that town – one a direct route that will get you there faster you make and hold. but could be congested, the other a traffic-free road that circles the town and takes twice as long. 3

Risk versus The more risk you take, the more your investment has the potential to grow. There are no certainties with investments, so taking a higher risk does not guarantee reward a higher return and you may not get back your original investment (known as the capital). The risk/reward ratio explained Be wary of stockmarket The illustration below shows how risk can affect your fluctuations investment. If you choose a low-risk investment, the It’s important to remember that no investment is initial sum invested is not expected to grow very much. guaranteed – the stockmarket will fluctuate so your But if you choose a higher risk investment, your initial investment may not grow as predicted and you may not sum could grow considerably. get back your original sum (capital). Risk is the possibility of losing some, or all, of your capital (your original investment). Risk refers to uncertainty. All investments carry a level of risk. 4

Balancing risk – It might seem sensible to always choose a low-risk investment, but this could leave you too much or without enough money for your needs, especially in the long term. Over-confidence could encourage you to take too much risk – a high-risk investment too little? may have performed well in the past, but that’s no guarantee of future growth. The problem with not taking Balancing the risk enough risk If you’re too cautious with your investment, you may not grow Volatility Timescale your money as much as you’d like to. For example, if you’re investing over the long term for your retirement, but choose Perception Capital growth a low-risk investment, you may not have enough to live on when you come to retire. Tolerance Regular income In the UK people will, on average, need an income to support Risk Your investment themselves for 20 to 30 years after retirement at aged 65. objectives To ensure you have enough to meet your needs, you may choose a higher risk investment early on and then switch to a lower risk investment with a regular income on retirement. The problem with taking too much risk Being too confident and taking too much risk could also leave So although a high-risk investment may grow your money you without enough money for your needs. If you choose a over the long term because you can ‘ride out’ the short- high-risk investment that has performed well in the past, you term dips, putting your money into a volatile investment for may have high expectations of its future performance. But as a short time may leave you with very little growth or less than past growth is no guarantee of future growth, you may not you originally invested. make as much as you expect, which is particularly problematic if you need a certain amount of money to pay off your mortgage or to live on during your retirement, for example. Taking too much risk in the short term could also prove problematic. High-risk investments may be volatile, which means they can fluctuate quite a lot year on year. 5

Different types of Saving in a bank or building society is low risk, but your money also has the least investment and opportunity to grow here. their level Bonds and equities give you more opportunity to grow your money, but your original investment (capital) is not secure. of risk Investing in property is considered relatively stable compared with the returns from bonds and equities, but your capital is still at risk. Whatever your investment objectives may be, it is Investing in equities important to be sure that your portfolio’s balance Equities are shares in a company. The growth of your between risk and return is right for you. For example, investment depends on the fortunes of that company, taking on too much investment risk could result in your the industry it operates in and the general economic capital fluctuating, while not taking enough risk may climate. Although there is no limit to how much your mean that your investment may struggle to meet your investment could grow, there is also no limit to how capital growth requirements. much a share price can fall as well. You may not recoup Investing in a bank or your original investment. building society Investing in property Up to £75,000 of your money is safe in a bank or The amount of income you can make from property building society as it is covered by the Financial Services can fluctuate according to the general trends of the Compensation Scheme. But your money will only grow residential or the commercial property market in the in line with interest rates, so when interest rates are low, economy. Although property is considered more stable as they are currently, your capital growth is quite limited. than equities, your initial investment is still not secure. Investing in bonds For more information please see our Spin-free guides to Investing in bonds is like giving a fixed-term loan to a bonds, equities and property. company (or a government). You can receive income from interest on the ‘loan’ for an agreed length of time. Bonds are considered to carry less risk than other types of investments; however, the amount of risk varies according to how secure the bond issuer is considered to be. Bonds issued by governments are generally considered to be more secure. 6

Make sure you are comfortable with the level of risk you decide to take with your Find your level investment. of risk Choose an investment portfolio with the right balance of risk and return for you. The length of time during which you can invest, combined with your investment goals, will help you choose the right level of risk for you. How to find your level of risk As you’ll have read on page 5, there are problems with your investment. To find the level of risk that’s right for taking too much risk and not taking enough risk with you, you need to think about your plans: How much time How much money do you have would you like to have to allow your at the end of your investment to grow? investment period? £ 7

Find your level of risk continued Performance of dierent asset classes over 25 years (£1,000 initial investment) adjusted for inﬂation £5,000 UK equities Bonds Commercial property UK building society £4,000 £3,000 £2,000 £1,000 £0 Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 Stockmarket prices may ﬂuctuate and you may not get back the amount that you originally invested. Past performance is not a guide to future performance. UK Equities shows the performance of £1,000 invested in the FTSE All-Share Index over 25 years with net income reinvested. Bonds shows the performance of £1,000 invested in the FTSE All Stocks Index over 25 years with gross income reinvested. Commercial Property shows the performance of £1,000 invested in the IPD Index over 25 years with net income reinvested. UK Building Society shows the performance of £1,000 invested in a typical building society account (where up to £75,000 of your money is secure through the Financial Services Compensation Scheme, unlike a stocks and shares or ﬁxed interest investment which are less secure) over 25 years with net income reinvested. Source: Morningstar and M&G Statistics, to end Sep 2016. Your personal investment timeframe and your individual to your investment than bonds or property. On the circumstances (for example, your age and stage of life) other hand, cash carries the lowest level of risk, but as will give you an idea of whether it would be appropriate to a result, has historically produced the lowest returns. take more risk in order to achieve your investment goals. We believe that regularly reviewing your portfolio is Different asset classes have different risk and return fundamental to long-term success. profiles. For example, equities may produce the highest long-term returns, but depending on the prevailing economic situation, they may also carry a greater risk 8

Common types Each type of investment (asset class) has its own level of risk and return. of risk with The risk and return profile of an asset class is based on past performance and market conditions. investment Asset classes are affected by a number of different types of risk – some types of risk are common to all asset classes. Common types of risk explained As share prices fluctuate according to company We introduced you to different asset classes on page 6 performance, stockmarket trends and other factors, of this guide. Each asset class can be affected by one or there is greater capital risk. While there is no limit to more types of risk. how much a share price can rise, there is also no limit to how much it can fall – you may not get back the Here are some common types of risk and a guide to initial sum invested. the asset classes affected by them: Capital risk Capital risk in bonds When you invest in bonds, you ‘loan’ a company Every investment, even cash above £75,000, carries the or government your money over a fixed period risk that you may not get back your initial sum invested of time. That company or government will pay (capital). This is known as capital risk. you ‘interest’ on the loan for the length of the bond As we explained before, equities and bonds carry a period, at the end of which it will pay back your capital. higher capital risk than cash. But out of the two, equities The capital risk in bonds comes if the company or has a greater capital risk. government goes bankrupt during your investment Capital risk in equities period. But even if that happens, bondholders are more Equities are shares in companies. When you buy equities likely to recover some of their losses than shareholders. you become part-owner of the company and your investment successes depend on the fortunes of the company. 9

Common types of risk with Currency risk investment This is a risk associated with investing overseas or in continued international companies. As a UK-based investor, if you invest overseas, you’ll need to convert your money back into sterling when you want it back. As currency exchange rates change, Credit risk so will the value of your investment. This is a risk associated with bonds. If sterling strengthens against the currency of the If a company or government that has issued bonds country in which you’ve invested, this will lower the (also known as the issuer) fails to make interest payments value of your foreign investment. If sterling weakens, or repay the initial loan amount, a ‘default’ occurs. your foreign investment will increase in value. Each issuer has a credit rating that indicates its ability Inflation risk to pay back its loans. If an issuer’s credit rating is Inflation risk can affect all types of assets. downgraded (by a credit rating agency) it suggests that The higher the rate of inflation, the lower the actual the risk of it defaulting has increased, and the value of value of future returns. This is because as the rate of bonds issued by the company or government could fall. inflation increases, money devalues in real terms. For If this happens, an issuer might choose to offer higher example, you can’t buy as much with £5 today as you interest payments to entice investors who are taking could 30 years ago. a greater risk by lending money to that company or government. As you’ll remember from the graph on page 8, inflation Governments with solid public finances typically have causes a purely cash investment to devalue over time. a lower probability of default on their debt. Therefore, So ideally, any investment you make must beat the rate they are more likely to pay a lower level of interest. of inflation to grow your money in real terms. Companies tend to offer larger interest payments on their bonds to compensate for the higher risk that they could default. 10

Common types of risk with investment continued Interest rate risk Market risk This type of risk affects cash savings and inversely Market risk can affect all types of investment. affects bonds. Market risk is the risk of an entire market collapsing Bank and building societies will increase or decrease the rather than just an individual company. This could interest they pay on deposits in line with the Bank of happen as a result of an economic shock or a major England’s rates. So if interest rates are low, your cash institutional failure that triggers a chain reaction savings in a bank or building society may not grow affecting the entire market. very much. Generally, bond prices tend to move in the opposite direction to interest rates. When interest rates go up, the fixed payments offered by bonds look less attractive. But if interest rates are low, the fixed payments look more attractive and may be more than you might get from your bank or building society. 11

Ways to diversify Plan your investments well and you’ll also manage your risk well. and manage Even if you’ve chosen a portfolio that suits your level of risk and needs, you should review your level of risk and investment goals on a regular basis. your risk Diversification is the key to minimising your risk. Ways to minimise risk Diversification Investing in funds Quite simply, don’t put all your eggs in one basket. By investing in a fund rather than an individual A diversified portfolio that includes higher risk company, your money is spread across shares or bonds investments, such as equities, as well as lower risk from many different companies, sectors and, in some investments, such as bonds, will help to manage and cases, regions. The risk to the overall investment is lower your risk. This is because if the equities in your reduced since you are not relying on the fortunes of a portfolio are volatile and dramatically decrease in value, single entity. If one company in the fund underperforms, the fixed interest from your bonds should still give you the others could cushion the blow. a regular income and help to give your investment an The cost of investing in a fund can often be less than overall consistent level of performance. buying shares or bonds one at a time. This is because the costs are generally lower, the larger the sums involved. Also, an experienced fund manager can select and manage those assets on your behalf. 12

Ways to diversify and manage your risk continued Investing for the long term Investing regularly As you’ll remember from the graph on page 8, while Investing at regular intervals can also help reduce the value of equities may fluctuate month on month, risk because markets rise and fall all the time. When it can increase over a longer time period. Many types the market price is low, a greater number of shares or of investment take a tumble for all kinds of reasons bonds can be bought for the same money. At other (see previous section on common types of risk), but if times, when the market is high, the opposite is true. you invest for the long term, it’s possible to ‘ride out’ If you buy continuously through the ups and downs, these short-term fluctuations. But please note, there the average price of the investment can be lower than is no guarantee of future growth in any market or if you make one lump sum investment. Of course, when investment type. the market falls, the existing investment will be worth The longer you invest, the bigger the potential effect of less. But, over time, regular investments can help to compound performance on the original value of your smooth out the market’s peaks and troughs. investment. Many of you will be familiar with the term ‘compounding’ from owning cash savings accounts. Compounding refers to the process whereby interest on your money is added to the original principal amount which then, in turn, earns interest. Your investments can benefit from compounding in a similar way, if you reinvest any income you receive, although you should remember that the value of stockmarket investments will fluctuate, causing prices to fall as well as rise and you may not get back the original amount you invested. 13

A few final The level of risk that’s right for you will depend on your stage in life and your future plans. reminders If your life plans change, your attitude to risk may change too, so you’ll want a portfolio that’s flexible enough to change with you. on risk Don’t forget that not taking enough risk can be just as problematic as taking too much risk. Don’t forget… Important note Choosing your level of risk is all about the reward The views expressed in this document should you’re seeking. Think about your life plans and when not be taken as a recommendation, advice or a and how you’ll want a return on your initial investment forecast. The value of stockmarket investments (capital). Once you’ve decided this, you’ll know what will fluctuate, causing fund prices to fall as well type of risk is right for you. as rise, and you may not get back the original amount If you’re saving for retirement, for example, you may you invested. Past performance is not a guide to be willing to take a higher risk earlier in your life for future performance. potentially higher returns. This is because even if your investment doesn’t perform well, you still have time to make other plans. But closer to your retirement age, you may choose to switch to a lower-risk investment to help protect your capital. 14

Glossary Investment terms The following are explanations of some of the terms you would have come across in this guide. Asset Dividends Volatile Anything having commercial or exchange value Dividends represent a share in the profits of When the value of a particular share, market or Athat is owned by a business, institution or individual. a company and are paid out to a company’s sector swings up and down fairly frequently and/or Asset class shareholders at set times of the year. significantly, it is considered volatile. Category of assets, such as cash, company shares, Equities Volatility fixed income securities and their sub-categories, Shares of ownership in a company. The degree to which a given security, fund, or index as well as tangible assets such as real estate. Portfolio rapidly changes. It is calculated as the degree of Bond deviation from the norm for that type of investment A combination of investments held by an investor. over a given time period. The higher the volatility, A loan in the form of a security, usually issued by the riskier the security tends to be. a government or company, which normally pays a Return fixed rate of interest over a given time period, at the The amount of money you’ll make from an end of which the initial amount borrowed is repaid. investment. Capital Risk Z Refers to the financial assets, or resources, that A ratio comparing the expected returns of an a company has to fund its business operations. investment with the amount of risk undertaken. Capital growth Risk/reward ratio Occurs when the current value of an investment is A ratio comparing the expected returns of an greater than the initial amount invested. investment with the amount of risk undertaken. Diversification Shareholder The practice of investing in a variety of assets. This Someone who owns at least one share in a is a risk management technique where, in a well- company – they are part-owner of that company diversified portfolio, any loss from an individual through the shares they have. holding should be offset by gains in other holdings, thereby lessening the impact on the overall portfolio. 15

This brochure is part of our range of Spin-free guides: Spin-free guides aim to give you the basics In vesting about investing, to help you make informed Eq uities decisions about your financial goals and how to reach them. The value of investments, and the income from them, will fluctuate which will cause the fund price to fall as well as rise and you may Risk I ncome not get back the original amount you invested. We are unable to give financial advice. If you are unsure about the suitability of your investment, speak to a financial adviser. The views expressed in this document should not be Pr operty taken as a recommendation, advice or forecast. Bond s Multi -asset investing 16

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