How to manage investment risk
While you can’t get rid of investment risk completely, you can take steps to reduce it and maintain a level you’re comfortable with.
Please remember, investment value can go up or down and you could get back less than you invest. The value of international investments may be affected by currency fluctuations which might reduce their value in sterling.
Managing investment risk involves figuring out what you’re prepared to put on the line while being okay with potentially losing some or all of your money.
It also involves diversifying investment risk, and asset allocation.
Let's dive into various risk management techniques.
What is risk management in finance?
Investment risk refers to the possibility of making a loss when investing. Risk sits on a scale, as all investments involve some risk. The level of risk can be nearly zero, but there will always be some risk attached and it’s your responsibility to balance risk and reward.
It’s important to take the time to fully understand investment risk before committing, though risk management strategies can be applied to mitigate it within your portfolio.
Principles of risk management
The fundamentals of investment risk management start with determining how risky an investment is, then deciding what action to take based on that information.
Risk can be quantified. This can be a complicated process, but there are some basic concepts that don’t require high-expertise — such as assessing historical data or company credit scores.
You’re probably already familiar with some of the processes of managing investment or financial risk. For example, banks will run a credit check on you before approving credit or a loan. If you already invest, you may opt for a diverse portfolio of shares, funds and other assets across different sectors, or you might pause your monthly trades to replenish your rainy day savings after needing to use some to repair your car. These are all ways that investors will help manage the potential impacts of risk.
Along every step of risk management, you need to understand your own risk tolerance and determine what you’re personally willing to lose. No one can fully decide this for you, as it’s personal to your finances and goals.
Five risk management techniques
You don’t need to become a professional risk manager to keep on top of your risk level. Nearly everyone can take these five essential and well-known risk management techniques and apply them to the financial and investment world. They can also be applied to other scenarios which involve risk.
| Technique | What it involves | Real world example |
|---|---|---|
| Avoidance | Avoiding risk completely. | You’re considering investing in a popular stock. However, after looking at a company’s historical performance over the last five years, you decide it’s been too volatile for your risk tolerance level and you choose not to invest. |
| Retention | Accepting the existence of potential risk, even if there is the option to avoid it or manage it differently. | Investing in a new company in an emerging sector because you’ve done your research and believe the company is set to do great things. Your risk tolerance allows you to consider that the potential rewards are worth the leap of faith. |
| Spreading / Sharing | Spreading your money across two or more investment types or sectors. | Instead of focusing on one investment, you diversify your portfolio by investing in multiple different companies and sectors. Sharing the load reduces the dependence on any single one to perform. |
| Loss Prevention and Reduction | When risk can’t be avoided, you take actions that can minimise the impact of losses. | Only trading company stocks that are regulated by the Financial Conduct Authority (FCA), and are therefore protected by the Financial Services Compensation Scheme (FSCS). |
| Transferring | Risks are passed on to another party. | Purchasing life insurance policies to transfer the risk of premature death to the insurer. |
How to reduce investment risk
While there is no way to entirely eliminate risk, there are several strategies to help reduce risk levels when investing. Though there are plenty more tactics out there, here are five strategies you can take into investment planning and management:
1. Asset allocation
Asset allocation refers to how your portfolio is broken down into investment types and classes. How your portfolio is structured will depend on your tolerance to risk. If you have a higher risk tolerance, your portfolio might consist of 80% equities and 20% bonds. But if you’re a more conservative investor, your portfolio could be the reverse and consist of mostly low-risk investments.
You can fine-tune your portfolio over time to make sure it suits your needs, goals, and appetite for risk.
2. Diversification
A balanced portfolio might include a range of risks, but this doesn’t necessarily mean you have a diverse portfolio. To achieve diversification, not only do you need a range of risk levels, but also diverse holdings in your portfolio.
If you only invest in one company, you open yourself up to ‘single-security risk’, which means your investment relies on the price of one single holding. Similarly, focusing investments in just one sector means your assets may all be affected by the same external factors.
However, if you invest across various sectors and companies, it’s less likely that you’ll lose your entire investment as some of them will grow to offset any potential losses. Bear in mind, this isn’t guaranteed and you should still be prepared to lose everything you put in.
3. Pound-cost averaging
Much like a consistent direct debit to a subscription service, pound-cost averaging involves drip-feeding a fixed amount of money into the market on a regular basis — regardless of the market performance.
Rather than investing a lump sum of money in one go, you spread the costs. For example, you could buy £12k units of a specific stock on one occasion and risk overpaying the value, or you could invest £1k into that same stock over twelve months and potentially buy units at a lower cost at some point due to market fluctuations.
Most investment platforms offer drip-feeding, such as our free regular investing service - which allows you to set up a monthly direct debit to invest little and often.
4. Monitoring your portfolio
You have the ultimate say over your portfolio. Make sure you keep an eye on your investment performance, scheduling in regular check-ins. If you feel uncomfortable or unsure about the level of risk you’re currently taking, you can take action to reshuffle your portfolio. This could involve withdrawing your money from a risky investment and reinvesting in a safer option.
5. Let someone else handle the risk for you
Balancing and rebalancing your investments to manage risk can be time-consuming. There are plenty of options which allow you to give up some of the control, such as mutual funds, ETFs, or managed accounts.
The ii Managed ISA offers you the choice of five different risk profiles to match your appetite, ranging from cautious and conservative to aggressive and adventurous.
Risk Warning: The price and value of investments and their income fluctuates: you may get back less than the amount you invested. If you are unsure about the suitability of a particular investment or think that you need a personal recommendation, you should speak to a suitably qualified financial adviser. Please note, the tax treatment of these products depends on the individual circumstances of each customer and may be subject to change in future. If you are uncertain about the tax treatment of the products you should contact HMRC or seek independent tax advice.
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