An investment can grow your money. It can also fall in value, deliver less income than expected, or become difficult to sell when you need the cash.
These possibilities are part of investment risk.
Understanding risk helps you look beyond an attractive return and ask a more useful question: what could go wrong, and how would that affect my plans?
This guide explains the main types of investment risk, how they work in everyday situations, and what you can do to manage them.
What Is Investment Risk?
Investment risk is the possibility that an investment produces an outcome that harms your financial position or prevents you from reaching your goal.
That might mean losing part of your original investment, earning less than expected, or being unable to access your money when you need it. Even an investment that preserves its cash value can lose purchasing power if its return falls behind inflation.
For example, imagine you invest 10,000:
- Its value falls to 8,000.
- You expect income of 500 a year, but receive only 200.
- You need the money urgently, but cannot find a buyer.
Each situation illustrates a different way an investment can disappoint you.
All numerical examples in this guide are hypothetical and exclude fees and taxes unless stated otherwise.
How Risk and Return Are Connected
Investors generally expect greater potential returns when they accept greater uncertainty or the possibility of larger losses.
But taking more risk does not guarantee that you will earn more money. A risky investment can perform poorly, and some can lose their entire value.
Consider two hypothetical investments:
| Investment | Possible outcome | Main consideration |
|---|---|---|
| A deposit paying a fixed rate | More predictable interest, subject to its terms | Whether the return keeps pace with inflation and what protections apply |
| Shares in a growing company | Gains if the business performs well; losses if expectations deteriorate | Uncertainty about the company and the price investors will pay |
A promised return alone tells you very little. You also need to understand how the return would be generated and what could prevent it from being paid.
Main Types of Investment Risk
Several risks can affect the same investment at once.
1. Market Risk
Market risk is the possibility that broader market conditions reduce the value of your investments.
For example, a recession or a sharp change in investor confidence can cause many share prices to decline together. Your investment may fall even if the company itself remains profitable.
Our guide to bull markets and bear markets explains how these wider market movements work.
2. Company-Specific Risk
Company-specific risk comes from problems within an individual business, such as falling sales, heavy debt or unsuccessful management decisions.
If that company fails, shareholders may lose their entire investment. Owning a recognisable brand does not remove this risk.
3. Concentration Risk
Concentration risk arises when too much of your money depends on one company, sector, country or closely related group of investments.
For example, owning five technology funds may appear diversified. But if they hold many of the same companies, your money may still depend heavily on the same businesses.
Your employment can also add to concentration. Holding substantial shares in your employer means a business setback could affect both your income and your investments.
4. Credit or Default Risk
Credit risk is the possibility that a borrower fails to make required interest payments or repay the money it owes.
This matters when you buy bonds or other debt investments. A high advertised yield may reflect doubts about the borrower’s ability to repay.
Being entitled to repayment does not mean repayment is certain.
5. Interest Rate Risk
Interest rate changes can affect investment values, particularly bonds.
When market rates rise, existing fixed-rate bonds generally become less attractive, and their prices tend to fall. This matters if you sell before maturity. Longer-term bonds are generally more sensitive to rate changes.
For example, buyers may be unwilling to pay full price for a bond paying 3% if comparable new bonds offer 5%.
6. Inflation Risk
Inflation risk is the possibility that your money grows more slowly than prices, reducing what it can buy.
If your balance rises by 2% while prices rise by 4%, you have more money in cash terms but less purchasing power. Our inflation explained guide explores this further.
7. Liquidity Risk
Liquidity risk is the possibility that you cannot sell an investment quickly at a reasonable price.
A property may take months to sell. A thinly traded security may have few buyers. Some investments restrict withdrawals.
If you need cash urgently, you may have to accept a lower price or wait longer than planned.
8. Currency Risk
Currency risk arises when exchange rate movements affect the value of a foreign investment in the currency you use.
An overseas investment might gain value in its local currency, yet produce a smaller gain—or a loss—when converted back into your home currency.
International investing can also involve different political conditions, regulations and investor protections.
Is Volatility the Same as Investment Risk?
Volatility describes how much an investment’s price moves. It is one aspect of risk, but it does not capture every possible problem.
A price decline can matter greatly if you need to sell. An investment with little visible price movement can still be difficult to sell or exposed to default.
Consider this hypothetical example:
You invest 10,000, and its value falls by 20% to 8,000. Returning to 10,000 requires a 25% gain, because the recovery starts from a smaller amount.
| Starting value | Loss | Value after loss | Gain needed to recover |
|---|---|---|---|
| 10,000 | 10% | 9,000 | 11.1% |
| 10,000 | 20% | 8,000 | 25% |
| 10,000 | 50% | 5,000 | 100% |
The calculations show why substantial losses can be difficult to recover from. They do not predict whether an investment will recover.
Risk Tolerance vs Risk Capacity
Two questions help you assess how much risk fits your situation:
- Risk tolerance: How comfortable are you with uncertainty and losses?
- Risk capacity: How much loss can your finances absorb without jeopardising essential spending or important goals?
Someone may feel comfortable taking risks but have little financial capacity because they need the money soon. Another person may have substantial savings but find market declines difficult to tolerate.
For example, imagine two people each have 10,000.
One needs it for a home deposit next year. The other has separate emergency savings and intends to invest it for retirement in 25 years.
The same investment could have very different consequences for each person. The amount invested is identical; the purpose and deadline are different.
Does Investing for Longer Reduce Risk?
A longer time horizon may give you more flexibility to remain invested through a downturn. It does not guarantee recovery or protect every investment from failure.
Even after many years of growth, a market decline shortly before you need to withdraw can disrupt your plans. Your circumstances may also change, forcing you to sell earlier than expected.
For example, an investment grows from 10,000 to 18,000, then falls by 25%. It is now worth 13,500.
You remain ahead of your original investment, but you may still fall short if your goal requires 18,000.
Our guide to long-term investing explains how to think about investing over longer periods.
How to Manage Investment Risk
Managing risk starts with understanding what you own and what you need the money to do.
Match Your Investments to Your Goal
Write down the purpose of the money, when you expect to need it, and whether you could delay that goal after a loss.
Money needed soon generally leaves less room to absorb a significant decline.
Diversify Your Holdings
Diversification spreads exposure across different investments. It can reduce the impact of problems affecting one holding, but it does not guarantee profits or prevent losses during a broad downturn.
Check what your funds actually own. Several funds with overlapping holdings may provide less diversification than their number suggests. See our guide to portfolio diversification.
Consider Your Overall Asset Allocation
Asset allocation means deciding how to divide your money among assets such as shares, bonds and cash.
The appropriate mix depends on your goals, timeframe and ability to tolerate losses. There is no single allocation that suits everyone.
Plan for Access to Cash
Before committing money, check withdrawal restrictions, settlement periods and early-exit costs.
Keeping accessible funds for foreseeable spending and emergencies can reduce the chance that you must sell an investment under pressure.
Understand the Product Before Buying
Be able to explain how the investment generates returns and how it could lose money.
High-pressure selling and promises of high returns with little or no risk are warning signs that deserve further investigation.
Review Your Portfolio as Circumstances Change
Changes in your goals or finances may call for a different approach. Market gains can also cause one part of your portfolio to become larger than intended.
Rebalancing can restore your chosen allocation, although transactions may involve costs and taxes.
A Checklist Before You Invest
Before buying an investment, ask:
- What is this money for, and when will I need it?
- How does the investment generate returns?
- What could cause a loss?
- What would a substantial loss mean for my plans?
- How quickly could I access my money?
- Does this duplicate risks I already have?
- What fees, taxes and exit restrictions apply?
- Who provides or holds the investment, and what protections apply?
If you cannot answer these questions, gather more information before committing money.
Frequently Asked Questions
Can investment risk be eliminated?
Risk can be managed, but it cannot be eliminated entirely. Different products expose you to different risks, including loss of capital and loss of purchasing power.
Does higher risk mean higher returns?
No. Greater risk may come with greater potential returns, but the actual outcome can be a loss.
Are ETFs automatically diversified?
No. A broad fund may hold many different businesses, while a narrowly focused ETF may concentrate on one sector or theme. Check the underlying holdings.
How much investment risk should I take?
That depends on your goals, timeframe, financial capacity and comfort with losses. A useful starting point is to consider the consequences of a loss for each goal separately.
This article provides general educational information and does not recommend a particular investment or portfolio.