Understanding Investment Risk: A Beginner's Guide to Returns

Investments that can grow faster can also fall further. That trade-off sits behind most decisions you make as an investor, starting with how much to keep in cash and how much in shares.

What investment risk means

Most people think of risk as losing money: you put in £10,000 and later it is worth £8,000. There are other kinds too.

• Volatility: the value of your investment moves up and down, sometimes sharply, even if it ends up higher over time.
• Inflation risk: your money grows more slowly than prices rise, so it buys less each year.
• Liquidity risk: you cannot sell quickly, or only at a poor price, when you need the cash.
• Concentration risk: too much of your money sits in one company, industry or country.

Inflation risk catches out cautious savers. Leave £10,000 in an account paying 3% for ten years while prices rise by 4% a year, and the balance grows to about £13,440, but in today's money it buys only what £9,079 buys now.

From lower risk to higher risk

Cash in a bank or building society account is the lowest-risk place for money. If the bank fails, the FSCS (Financial Services Compensation Scheme) protects up to £120,000 per person per banking licence. The trade-off is that cash returns often fall behind inflation over long periods.

Government bonds come next. A UK gilt is a loan to the government that pays a fixed amount of interest and returns your money on a set date. If you hold a gilt until that date, the risk is low. Gilt prices do move in between, though, and when interest rates rose sharply in 2022, many UK gilt funds lost a fifth or more of their value.

Mixed funds hold both shares and bonds. The bonds usually cushion falls in the shares, in exchange for lower expected growth.

Shares carry the most risk and, over long periods, have delivered the highest returns. A UK-only or emerging markets fund is narrower than a global one, and a handful of individual shares is riskier still.

How long you are investing for

When you need the money matters more than almost anything else. If you are saving for retirement in 30 years, a fall of 30% in one year is painful but there is time to recover. If you need the money for a house deposit in two years, the same fall could force you to sell at a loss or delay your purchase.

A common rule of thumb is to keep money you will need within five years in cash. MoneyHelper, the free government-backed guidance service, also suggests an emergency fund of three to six months' essential spending before you invest.

Try our [investment calculator](/investment-calculator) with, say, 3% a year for a cautious mix and 6% for mostly shares, to see what the difference could mean over your time frame.

Spreading your money around

Diversification means owning many different investments so that a problem in one does not sink the whole lot. A global index fund owns shares in thousands of companies across dozens of countries. If one company goes bust, you barely notice. If you own five shares and one goes bust, you lose a fifth of your money.

Spreading your money does not protect you from a fall across the whole market. In 2008, and again in early 2020, global shares fell together. What it removes is the risk of one company or one country dragging you down. Japan is the standard warning: its main stock index peaked in 1989 and did not return to that level until 2024, 34 years later.

Falls are temporary unless you sell

A fall in value only becomes a real loss when you sell. The maths makes selling in a downturn expensive: after a 20% fall you need a 25% rise to get back to where you started, and after a 30% fall you need about 43%.

Global shares fell by around a third in a few weeks in early 2020, then recovered within the year. After 2008 the recovery took several years. Investors who sold near the bottom missed the rebound. Past recoveries do not guarantee future ones.

If your investments drop and you want to sell, ask two questions. Has the date you need the money changed? Has anything changed about what you own, beyond its price? If the answer to both is no, selling usually locks in the loss.

Tolerance and capacity

Risk tolerance is how big a swing in value you can live with: picture your £20,000 pot showing £15,000 one morning. Risk capacity is how much loss you can afford, based on your income, savings, debts and how long you have.

Aim for the lower of the two. If you take more risk than your nerves can handle, you are likely to sell in a panic. If you take less than you can afford, your money may grow too slowly to reach your goal.

A sensible place to start

For most UK beginners, a low-cost global index fund inside a Stocks and Shares ISA is a sound first step. You can pay in up to £20,000 a year, and you pay no tax on the growth or income. Look at the total yearly cost, including the platform fee and the fund charge, as a difference of 0.5% a year adds up over decades.

One point people often misunderstand: the FSCS limit for investments is £85,000, and it only applies if your platform or fund provider fails. It does not cover your investments falling in value. That is the risk you accept in return for the chance of higher growth.