Different Types Of Investment Risk For Clients

Question 1

What are the four main types of investment risks for retail clients/ investors?

Answer 1

1. Capital Risk
2. Inflation Risk
3. Interest Rate Risk
4. Shortfall Risk

Retail investors often focus only on capital risk, without considering how avoiding risk may expose them to other financial risks.

Question 2

What is capital risk?

Answer 2

1. The risk that an investment (stocks/ bonds) may lose value over time.

E.g. Sarah invests £10,000 in a stock portfolio. After a year, due to market downturns, its value drops to £8,000. This loss in value represents capital risk.

Question 3

What is inflation risk?

Answer 3

1. The risk that rising prices erode the purchasing power of capital and income.

E.g. Tom has £20,000 in a savings account earning 2% interest per year. However, if inflation is at 5%, the cost of goods and services is rising faster than his savings are growing. This means that although his bank balance increases, the real value of his money decreases.

Question 4

What is interest rate risk?

Answer 4

1. The risk that changes in the Bank of England’s base rate affect returns on deposit accounts.
2. This impacts the value of fixed-income investments like bonds or savings accounts.

E.g. Emma buys a 5-year government bond that pays a fixed 3% interest rate annually. A year later, BoE raises its base interest rate, and new bonds are now issued with a 5% return. Since Emma’s bond only offers 3%, it becomes less attractive to investors, reducing its market value.

Question 5

What is shortfall risk?

Answer 5

1. The risk that investment returns are insufficient to meet financial goals, requiring adjustments in return expectations, contributions, or time horizon.

E.g. James wants to retire in 20 years with a pension pot of £500,000. He initially invests in low-risk assets that return 3% annually. Later, he realizes that this return isn’t enough to meet his goal, meaning he must either invest more, take on higher risk, or delay retirement.

Question 6

What are examples of some other types of risks that may be relevant for consideration in the investment selection process for retail investors?

Answer 6

1. Credit risk
   Refers to the possibility that a borrower or bond issuer will default on their debt obligations, resulting in a loss for the investor
2. Market risk
   The potential loss of value in an investment due to changes in market conditions, such as stock prices, interest rates, or exchange rates.
3. Operational risk
   Arises from failures in internal processes, systems, or controls within financial institutions, which can lead to financial losses for investors.