Understanding investment risk… and returns

Are you the kind of person who would do a skydive without a moment's thought? Or does the idea of it make you feel ill? We're all different, and this translates into how we feel about risk generally, and therefore how we feel about taking risks with our finances.

It's well known that investing in the stock market is riskier than keeping your money in cash in the bank – but the more risk you take, the potentially higher your returns can be. Much like the skydive, the bigger the risk, the bigger the rush when you land back on earth.

It's important to understand how you feel about risk. If the idea of losing even a few pounds keeps you awake at night, keep your money in safer assets such as cash or bonds. When you're younger, it's wise to take more risk with your money as you've got a longer investment timeline, which allows your investments to ride out the peaks and troughs of the markets and should ultimately lead to a higher return.

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When thinking about risk, the first question to ask yourself is what you'd like to achieve. What are you investing for? If you need the money within a few years, consider less risky assets so you don't fall foul of a stock market dip that won't give your investment much time to recover. But if you're saving for the long term, you may be able to afford to take a little bit more risk. Whatever you decide though, you need to ensure you understand the risks and commitments before investing. If you are unsure you should consult a Financial Adviser.

Regardless of your investment time frame, it's imperative to spread risk across different asset classes, such as equities, bonds or property. By diversifying your portfolio across a range of asset classes and investments, you'll balance the risk of your portfolio, to ensure that if one asset class flounders, your entire savings won't fall with it.

The main asset classes of cash, stocks and shares, bonds (also called fixed income) and property all carry different types of risk – which determines the expected returns – so an investment portfolio should typically invest across a range to ensure you're not overexposed to one asset class should the market turn sour.

Of all assets, cash carries the lowest risk, but as a result the returns will be much lower. The average interest rate paid on an easy-access cash savings account stood at 0.66 per cent on 17 February 2015. Although inflation is currently very low due to a significant fall in the oil price, research from Linsey Congdon, Economic Analyst at Alliance Trust, shows that the average rate of UK inflation over the last five years is 2.9 per cent, meaning that the value of cash savings will generally be eroded over time. Bonds – the debt of companies and governments – are riskier than cash, but not as risky as the stock market.

Investing in stocks and shares on the stock market is riskier, but historically, returns have been much higher. For example, at the end of February 2015, the UK's leading share index – the FTSE 100 – hit a record level of 6,954.73, soaring 5.44 per cent over the past 12 months to 25 February. Of course, there's no guarantee that you'll get all the money back you invested, as the stock market can fall as well as rise – but the potential return is much higher.

There are two main ways to invest in the stock market. You can invest directly in the stock market by buying shares in individual companies, or indirectly through a collective investment scheme where your money is pooled with that of others to invest in a variety of stocks. The two most common forms of collective investment scheme are unit trusts (often referred to as OEICs – Open Ended Investment Companies) or investment trusts. Both are managed by a fund manager, but there are several key differences. OEICs are open ended, which means that the fund can continue to grow indefinitely as the fund manager will issue or redeem units for each new or departing investor. This means that the value of the shares is derived from the value of the underlying assets. With investment trusts, which are closed ended, the number of shares in issue are fixed, which means that the value of the shares is derived from the underlying assets, as well as the supply and demand for the shares, like any publicly listed company on a stock exchange.

By investing in a collective investment scheme, you'll actually be investing a small amount in a range of companies and assets, which will be determined by the style of the fund manager. They will typically invest in between 50 and 100 companies, and can be country, theme or sector specific. As your money will be spread across a variety of companies, it's far less risky than pouring your money into just one stock. You'll also benefit from access to a professional fund manager, who will make decisions about which stocks to buy and when to sell.

The easiest and most low-cost way to purchase stocks and pooled investments like funds and investment trusts are DIY platforms such as Alliance Trust Savings, where you can buy individual investments for your portfolio and decide yourself on the level of risk you'd like to take.

There's also the risk of buying into investments that won't go the distance. Your goal should be to take a sustainable approach to investment, and invest in solid, well-managed companies with a strong focus on providing products or services that adapt to our changing world. Investing in sustainable funds – which will in turn invest in companies involved in sustainable development industries such as education, climate change prevention and energy efficiency, among others – will ensure that your investment doesn't just benefit you, but the wider society in which we live.

Like many things, investment is all about assessing the individual risks and finding a balance between different asset classes and how you feel about your investment. Consider how weighing up the potential risk and return of your investments can help you build a balanced, successful portfolio.

For more on understanding risk and returns, click here.

Illustration by Sue Macartney-Snape for the Daily Telegraph.