What is risk?

In the realm of financial planning, the term "risk" is often met with apprehension and uncertainty. However, understanding risk is important for making informed decisions that align with your financial goals.

At its core, risk refers to the possibility of experiencing a loss or an outcome that deviates from what was expected. So, let’s look at the various types of risk, their implications, and how you can manage them effectively.

Types of financial risk

• Market risk, also known as systematic risk, arises from the fluctuations in the financial markets. Factors such as economic recessions, political instability, and changes in interest rates can impact the overall market, affecting the value of investments. For instance, a sudden drop in the stock market can lead to significant losses for investors.

• Credit risk is the possibility that a borrower will default on their debt obligations. This type of risk is particularly relevant for lenders and investors in bonds. If a company or government entity fails to meet its debt payments, it can result in financial losses for the investors.

• Liquidity risk occurs when an asset cannot be sold quickly enough to prevent or minimise a loss. This is common with investments in property or certain types of bonds that may not have a readily available market. The inability to convert assets into cash swiftly can pose significant challenges, especially in times of financial distress.

• Inflation risk, also known as purchasing power risk, refers to the erosion of the value of money over time. As the cost of goods and services rises, the real value of investments may decline. This is particularly concerning for long-term investors who need their investments to outpace inflation to maintain their purchasing power.

• Interest rate risk is the possibility that your savings or investments lose money because interest rates have moved up or down. For example, cash deposits are in a fixed account for five years earning 1% interest, but over time interest rates in general have risen to 2.5%. On the other hand, there is also a risk associated with not fixing a rate and interest rates falling.

• Over-diversification risk, as although diversification aims to reduce the total risks across a portfolio, if one investment performs really well its influence on portfolio returns could be diluted by poor performance in other investments.

The importance of risk management

Understanding and managing risk is a key aspect of financial planning, so how can you navigate the complexities of risk?

• Diversification involves spreading investments across various asset classes (such as property or shares), sectors, and geographical regions to reduce exposure to any single risk. By diversifying your portfolio, you can aim to mitigate the impact of poor performance in one area with better performance in another.

• Asset allocation is the process of dividing investments among different asset categories, such as stocks, bonds, and cash. The goal is to balance risk and reward according to your willingness and ability to take risk, your financial goals, and the investment horizon. A well-structured asset allocation strategy can help manage risk while aiming for optimal returns.

• Regular reviews are important as financial markets are dynamic, and your investment portfolio should reflect changes in your financial situation and goals. Regularly reviewing your portfolio ensures that it remains aligned with your risk appetite and objectives.

Risk is an inherent part of financial planning, but it doesn't have to be a source of fear. By understanding the different types of risk and implementing effective risk management strategies, you can make informed decisions that align with your financial goals.

At Schroders Personal Wealth. we are committed to helping you navigate the complexities of risk and potentially achieving financial stability.