7.2.2 Investment characteristics: risk
Risk is the amount of uncertainty about what you'll get back from an investment. It means the possibility that the investment may not make money, or that you could lose some or all of the money you invest.
Risk is based on several factors:
- the certainty you have about what the return will be. Low-risk investments have few unknowns and no surprises.
Example: With term deposits and government savings bonds, the return is stated in advance.
- the chance that you might lose the money you invest. With risky investments, your investments could lose value when you come to cash them in.
Example: Investments in land or the stock market, even in established companies, rise and fall in value. If you need to sell them when their value is down, you could lose money.
- the ability to see how the business works and what profits it is making. Some businesses and complicated investments are difficult to evaluate, so you can't tell whether they are a good value or not.
Example: Some businesses don't explain clearly how they expect to make money. Some investments (called derivatives) are based on the price of something else, such as the price of stocks on a foreign exchange. Unless you understand these investments well, you can't tell whether the buying price or the selling price is good for you.
Every type of investment has risks, and some risks are easier to understand than others. Experts use many different ways to analyze risk, and can spend time carefully evaluating a business. Unless you are a knowledgeable investor, you should get advice from a financial planner or advisor for any investments beyond simple ones such as term deposits and government savings bonds.
Risk vs. expected return
The return that an investor expects from an investment is related to its risk.
When you buy a risky investment, you expect to make more money. After all, if you were going to make the same return with a low-risk investment, you would choose the less risky one. So to attract investors, risky investments have to offer the possibility of a higher return.
But high risk means you will not necessarily get the return you expected. Perhaps you will make more than you expected, perhaps less. With many investments, such as company shares, there is also a chance that you will lose some or all of the money you invested. Risk means you can't be sure what the return will be.
When the risk is low, you must be willing to accept a lower return. If someone offers you an investment that promises high returns with a low risk, don't believe it. Higher returns mean higher risk.
You have to be comfortable with the risk you take on—if you can't sleep at night because you are worrying about your investments, you may be better off with an investment that offers lower risk. Your risk tolerance is an important personal factor to think about and discuss with your investment advisor. (For more on risk tolerance, see the next section Risk and your risk tolerance and section titled Investing goals.)
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