Understanding risk

I do not like taking risks when saving for the future. I have always preferred cash deposits as I know my capital is safe and what interest I will receive. I am now quite jealous though of the high returns being made by friends who have invested in international stock markets and I am therefore considering investing some money myself. What are the various risks of doing so and would interest rate movements up or down affect the returns on my stock market investments?

In general, the greater the risk you take, the more you potentially stand to gain or lose. There are however other risks to be aware of. Firstly, you must consider that by not investing, you are in fact carrying a risk.

With inflation around three per cent per annum, money that is not invested will lose approximately that much of its value each year. If you are therefore getting three per cent net interest in the bank, the real value after inflation of your deposit remains the same, i.e. it does not increase. This shows that whether you prefer the security of a bank account or are willing to accept the risks associated with equities of bonds, there are clear benefits to investing.

There is then market risk. This is the risk you take when you invest in the stock market. There is always the chance that short-term volatility will affect your holdings and this is one reason why investment companies use variations of the phrase "the value of your investments and the income from them can go down as well as up".

Even if you own very solid shares in blue chip international companies, an unexpected terrorist attack or sharp economic downturn can cause values to fall. But despite this, equities continue to be popular as major markets have historically moved up stronger over the longer term. And it is important to remember that one way to combat the effects of market risk is to think long term. Tying up your money for between five to ten years can give it a better chance of performing well as it has time to ride out the ups and downs of the market.

As regards interest rate movements, not only do they have an immediate impact on home loans or savings accounts but they are also key to the price of equities and bonds. This is because when interest rates rise, cash investments become relatively more attractive than equities or bonds. One way to reduce the risk of a rate rise or fall having an adverse effect on your portfolio is to diversify across a range of different equity, bond and cash investments.

In fact, not diversifying, or putting all your eggs in the one basket, is also a risk. Just consider, investing all your money in one area could mean that if values dip, your portfolio could be severely impacted. However, spreading your investments around can really help spread the risk. Finally, investing in different sectors such as financials or pharmaceuticals means that a fall in one area could be offset by rises in others.

Unless you are 100 per cent risk-averse, committing a proportion of your wealth to equities, bonds and property investments will diversify your portfolio and potentially enhance your returns over the medium to long term.

Past performance is no guide to the future and, except where amounts are guaranteed, the price of your investments (and the currency in which it is denominated) may fall as well as rise. Your personal tax situation will depend on residence. Always consult a professional adviser. This article does not intend to give investment advice and its contents should not be construed as such. Readers are encouraged to seek professional advice on their personal financial situation.

Mark Hollingsworth is the director of Hollingsworth International Financial Services - licensed by the MFSA to provide investment services under the Investment Services Act 1994 (IS/32457). Address any financial questions to: Mark Hollingsworth, c/o The Sunday Times, PO Box 328, Valletta CMR 01. Alternatively, he can be contacted on 2131-6298/9984-2614 or e-mail mh@hollingsworth-int.com