For investors that don’t have the stomach for volatility, there are many low-risk investment types to choose from in the UK. While it’s impossible to completely eliminate investment risk, various asset classes exist to mitigate it. And when used correctly, asset allocation can provide stability to an investment portfolio.
Let’s explore what investment risk actually is and what options are available for conservative investors.
What is investment risk?
Investment risk is defined as the uncertainty between expected returns and actual returns. The value of investments constantly moves up and down. This movement is called volatility, and some asset classes are more volatile than others.
Should investors avoid volatility? It depends on each investor’s goals and risk tolerance. Those willing to take on additional investment risk, can use the volatility in asset prices to try to capture higher returns.
For example, suppose a growth stock suddenly drops on news of supply chain disruptions. In such a case, a lucrative buying opportunity may have emerged, provided the long-term strategy of the underlying business remains intact.
But not everyone is interested in taking this higher-risk approach. Some investors may simply seek a way to protect their current wealth rather than grow it any further. That’s where low-risk investments come into play. These asset classes typically carry minor price volatility levels and offer investors greater financial security.
But it’s important to remember that nothing is guaranteed in the finance world. And even the safest-looking investments can fail to live up to expectations.
How to measure investment risk
Investment risk is defined as volatility according to Modern Portfolio Theory (MPT). However, in practice, it also comes in different forms that can be harder to measure. Generally speaking, investment risk falls into one of three categories.
- Volatility risk: The sudden appreciation or depreciation in an investment’s market price.
- Default risk: The likelihood of a business, fund, or government entity becoming unable to make promised payments on time.
- Liquidity risk: The likelihood of receiving less than the actual value of an investment if it needs to be sold quickly.
Measuring the latter two types of risk can get quite complicated. Fortunately, measuring volatility is reasonably straightforward using basic statistics.
The two primary metrics are:
- Standard deviation: This measures how dispersed the average returns of an investment are in relation to the mean. A high standard deviation in the world of finance means there is a significant spread in average returns and, therefore, greater volatility. Similarly, a low standard deviation means lower volatility.
- Beta: This measures how the average returns of an investment move in relation to a benchmark. For example, the performance of UK stocks is often compared to an index like the FTSE 100. A beta of 1.0 means the shares are perfectly correlated with the index. In other words, if the index increases by 1%, the stock has historically done the same. A beta of 2.0 means the shares have typically increased by 2% every time the index has risen by 1%. And a beta of -1 shows that the share price and benchmark index move in opposite directions. The greater the magnitude of an investment’s beta, the more volatile it has historically been.
Types of lower-risk investments
Savings account
While not often thought of as an investment, savings accounts are, in fact, financial products created by banks. Depositors give banks money to lend out to other businesses or individuals in exchange for a small piece of the interest on these loans. That’s how interest payments on bank account balances are paid.
Placing money in a savings account is arguably one of the safest investments an investor can make. Beyond the regulatory restrictions on banks, any deposits made in a bank account are insured by up to £85,000, thanks to the Financial Services Compensation Scheme.
Therefore, even if a bank suddenly goes bankrupt tomorrow, most depositors’ money would be safe. However, this high level of security comes with exceptionally low returns. In fact, savings accounts have significantly underperformed inflation over long periods, resulting in wealth destruction in terms of spending power.
Bonds
Bonds come in many shapes and sizes. Some offer significantly higher potential returns than others at the cost of taking on additional risk. Rating agencies like Moody’s and Fitch issue credit ratings to help investors navigate the bond market with a clear understanding of risk. The higher the rating, the lower the risk of default.
Some of the highest-rated debt instruments investors can buy are UK and US government bonds, also known as gilts and treasuries. With a government bond, investors are buying a nation’s debt in exchange for reliable coupon payments.
High-grade corporate bonds can sometimes offer superior returns. However, they are generally considered riskier than government bonds.
Annuities
Annuities are financial products issued by insurance companies. They provide guaranteed income for a fixed period of time and are a popular investment for pension savings.
The insurance company effectively places a bet on when an investor is likely to die. If an annuitant dies early, the insurance keeps the premiums and any remaining income that has yet to be paid out.
Therefore, annuities carry the additional risk of death that needs to be considered. An investor in poor health is unlikely to reap all the benefits of buying an annuity.
Preferred shares
The most common type of equity investment is purchasing ordinary shares. However, preferred shares offer investors slightly higher levels of security.
This form of equity is typically less volatile, offers priority over ordinary shareholders regarding dividend payments, and is further ahead in line with claiming assets in the event of bankruptcy.
Dividends on preferred shares are fixed and set when the preferred shares are first issued. Meaning even if the company cuts dividends on ordinary shares, preferred shares are not affected. However, there is often some flexibility for the business to defer dividend payments when times are tough.
Sadly, there are some caveats to consider. While fixed dividends can be advantageous, it also means that if the business raises dividends, only ordinary shareholders receive the benefits. Furthermore, preferred shares typically carry no voting rights.
Mutual funds
Instead of picking low-risk investments directly, investors can always defer these decisions to a professional by investing in an investment fund. These expose investors to various asset classes that can provide ample diversification and help build an appropriate investment portfolio with a relatively small number of transactions.
There are multiple different types of mutual funds. However, when it comes to low-risk investments, the three most popular are:
- Money market funds: The fund manager invests shareholder capital across various high-grade, short-term debt instruments. The returns aren’t spectacular but often exceed what can be achieved by a regular savings account. Due to their high level of liquidity, investors can quickly move money in and out of the fund. That’s why most investors use these as temporary parking spots for cash.
- Bond funds: Instead of picking low-risk bonds directly, investors can buy shares in a high-grade bond fund. This often provides greater levels of liquidity and leaves all the analysis and research to a professional.
- Index funds: Instead of picking stocks directly, investors can simply buy shares in an index fund that will pool and diversify shareholder capital across every business within a specified index. This provides instant diversification and lets investors mimic the performance of the stock market in general without needing expert knowledge.
Mutual funds offer a lot of conveniences. However, they still have some drawbacks. A fund’s performance, even with a professional at the helm, is never guaranteed, and it’s possible to lose money. Furthermore, these services aren’t free. Mutual funds charge recurring annual management fees that can eat into returns, which investors must consider before investing in this type of investment vehicle
How much can you earn on low-risk investments?
The level of return that can be expected on a low-risk investment ultimately depends on the asset class. As a general rule, the safer the investment, the lower the return an investor can expect.
Savings accounts and money market funds are arguably the safest types explored in this article. And subsequently, they provide the lowest levels of return. On the other hand, preferred shares and index funds are prone to more volatility, but offer superior levels of return.
Low-risk investments are ultimately defensive assets suitable under different conditions. And investors need to consider their risk tolerance, time horizon, and investment goals before making an investment decision.