Fortune doesn’t always favour the brave

Managing your risk is a key foundation to building and maintaining a successful investment portfolio. Weighing up the risks and rewards linked with different investments should form a big part of your decision-making process.

You might’ve heard the phrase “high risk, high reward” before? The phrase gets bandied around a lot, but it doesn’t always hold true in the investing world.

We take a look at why high-risk (volatile) investments – such as shares in smaller companies – should form a small part of your overall portfolio. That’s if they’re something you’re considering in the first place.

This article gives you information to help you choose the right level of risk for you. But it’s not personal advice. If you’re not sure what’s right for your circumstances, we have experienced financial advisers who can help.

How we look at risk

Risk as a concept has lots of different definitions. But to keep things simple, we can broadly split it up into two main categories:

Risk of loss – all investments carry some degree of risk, so it’s possible you could get back less than you invest. It’s the risk you take when investing – you’ll need to be comfortable with this if you’re looking to grow your wealth by investing.

Volatility risk – this is the most common way to measure risk. It measures how regularly and abruptly prices swing. If the price stays fairly stable, the investment has low volatility. If the price bounces around a lot, the investment has high volatility. Riskier investments are nearly always more volatile, which means they reach new highs and lows very quickly.

More risk, more return

As the general rule, the more risk (volatility) you’re prepared to accept, the higher the potential profit. Although there are no guarantees.

The graph below shows how the two major indices in the UK have both grown in size, but at different rates. Companies that make up the FTSE 250 are smaller in size and stature, so they’re riskier and more volatile than their larger counterparts in the FTSE 100. We recently looked at why company size matters when managing risk.

FTSE 100 vs FTSE 250 (2004-2024)

Past performance isn’t a guide to future returns. Source: Lipper IM, to 13 May 2024.

In this instance, the narrative of ‘higher risk, higher return’ has held true. The index that carries more risk with bigger price swings, the FTSE 250, has performed better than the index with less risk – the FTSE 100.

That’s not to say you’ve got to sit firmly in one camp or the other. It’s important to look at your overall portfolio risk rather than the risk of individual investments. Holding a mix of investments across different indices, geographies and sectors can help build a diversified portfolio with a level of risk tailored to you.

how to build and maintain a portfolio

More risk always pays off?

Not always. Stock markets don’t always perform as you’d expect.

As investments become more speculative and therefore more unpredictable, the likelihood of picking a loser becomes just as great as picking a winner. Share prices for speculative investments can swing wildly too.

While more risky investments have a higher expected return, the opposite is also true – the expected losses are much greater too.

The FTSE AIM index, which is a home for small and medium-sized UK growth companies – has been the worst performing UK index between 2002 and 2022.

Performance of the FTSE indices between 2004-2024

Past performance isn’t a guide to future returns. Source: Lipper IM, to 13 May 2024.

Is the extra risk really worth it? Could investing in more established companies with greater reliability offer a better way to achieve your financial goals? Ultimately that’s your call to make.

We think it’s important for investors to weigh up both the downside risk and upside potential. Any investment decisions should be made for the long term – that’s at least five years.

What level of risk is right for me?

Other risk factors

We’ve covered how and why the size of a company can impact volatility, but there are other risk factors to consider. These include, but are by no means limited to:

• Company-specific risk – no company is immune to bad news. Changes to management, annual results below expectations or negative speculation can see share prices decline, even for the biggest and best companies.
• Interest rate risk – fluctuations to interest rates can impact the prices of fixed-interest investments like bonds. It can also put downward pressure on share prices, especially in growth companies, as their future cash flows are worth less when interest rates rise.
• Inflation risk – we invest to grow the buying power of our money. If inflation beats the performance of your investments, the real return is negative and your money will be worth less in real terms. For example, inflation grows at 3% but your investments grow at 2%, your real return is -1%.
• Currency risk – movements in exchanges rates can impact the value of your investments. For example, if sterling becomes less valuable relative to the US dollar, any US investments would be worth less when converted back to sterling.
• Foreign investment risk – investing overseas, in less developed countries, adds more risk as there is often more political uncertainty and the state of the economy can quickly change. Investment in areas such as emerging markets and Asia can add volatility.

Ready to start your portfolio?

Our investment research team have put together some investment ideas to help you get started, but they’re not a personal recommendation to buy.

Mixed investment funds can be a great way to spread money across lots of shares and bonds – helping achieve greater returns with a relatively-lower level of risk.

For investors prepared to accept more risk, funds investing purely into individual company shares can offer an adventurous way to grow your wealth.

Investing in funds isn’t right for everyone. Before investing it’s important to check the fund’s objectives align with your own, understand the fund’s specific risks and if there’s a gap in your portfolio for that type of investment.

Remember, funds go down as well as up in value, so you could still get back less than you put in.