Invest with calculated risk Risk classes of funds and other investments

How much do you want to risk? What role do returns play for you? It’s not just either-or!

One thing is for sure – every investment involves a certain element of risk. In most cases, higher risk mean greater potential returns – but this also increases the risk that the investment will not pay off and that your invested money will be lost. 

Of course, the risks of individual investment products do not follow the principle of chance, but can be assessed and categorised using risk classes. As an investor, you can thus gain a better overview of which investments are suitable for you and which ones would exceed your personal risk tolerance. 

In this article, you will find all the information you need to better assess your own risk profile and make the best investment decision for you.

Since the enactment of the WpHG (German Securities Trading Act), financial service providers are legally obliged to review the extent to which their investment proposal is appropriate and suitable for customers. In order to make this review as universal as possible, financial products are categorised in different risk classes in order to provide investors with sound investment recommendations. 

It is, however, only broadly universal because the respective classification of securities, funds and other financial products is carried out by each bank individually – a uniform classification does not yet exist.

For this reason, various models are used to categorise investment risks: the risk classes of funds can be categorised, for example, using the SRRI model, which analyses the fluctuations in value over the last five years for its calculation.

The development of risk classes has created a tool that enables financial advisers to quickly and effectively assess the financial products they offer. 

However, risk classes can also help retail investors who want to find out independently about the risks of funds, equities, etc.  

For example, if you tend to be a more cautious investor, you can quickly and selectively eliminate financial products from the higher risk classes and look at investments more focused on safety. 

Likewise, risk classes can also help you if you want to achieve the highest possible returns and are not afraid of greater investment risks – in this case, investments in lower risk classes are probably not for you. 

Depending on the investment objective you are pursuing or your risk appetite, a look at the different risk classes of conventional investments can help you to get closer to a suitable investment strategy. You can find out how to do this here.

Most conventional investments, from funds to equities and derivatives, can be categorised into seven different risk classes. These classes range from a low number and low risk to the highest number and highest risk. 

At the same time, the categorisation of an investment product into the corresponding risk class is also closely linked to the respective return expectation – the lower the risk, the lower the potential return. 

Risk classes are therefore based on the well-known magic triangle of investment. The triangle allows any investment product to be placed between the three dimensions of security, returns and liquidity; no investment has all three characteristics at the same time. When considering the risk classes, the focus is particularly on the two aspects of returns and safety.

Risk class 1 financial products are the safest investments available on the financial market. These range from savings certificates to overnight and fixed-term deposits to building loan contracts. Although your money is kept safe here, it also provides only low returns.

Investors in overnight and fixed-term deposit accounts in particular not only face zero interest rates, but also have to pay penalty interest depending on the bank. Along with inflation, your money tends to lose value and purchasing power here.

Safety-oriented risk class 2 includes investment products such as traditional capital life insurance, open-end real estate funds or bond funds with excellent credit ratings, which invest in government bonds, for example. The risk of this class is slightly higher, but in any case it is still well suited for safety-oriented investors.

Conservative, safety-oriented investments include, for example, mixed funds, bonds with good credit ratings or fixed-income securities – i.e. investments with a clear focus on safety but slightly higher risk expectations. Your potential return is generally even lower with investment products in this risk class, but your investment is also well protected in return.

Financial products in risk class 4 no longer have the “safety-oriented” attribute; from here on, the focus increasingly shifts to returns. Investors who opt for investments in this risk class therefore take a moderate investment risk for a higher expected return.

The investment products in this risk class include various funds such as ETFs or equity funds, but also equities as individual securities. In addition to the potential issuer risk, these investments often carry additional price or currency risks.

The third highest risk class is primarily aimed at generating the highest possible returns. Investors’ risk appetite must therefore be high enough here to also accept losses for this objective. Investment products in this risk class include equities from third countries, medium-rated currency bonds or over-the-counter (OTC) shares that are traded off the stock market and decentrally.

For investments in products in risk class 6, high earnings potential can be expected. However, large fluctuations in value can also occur and thus significantly increase the investment risk. This risk class includes, for example, income-oriented equity funds, warrants or dividend funds. Investors who invest in products in this risk class must anticipate high losses or even total loss.

Risk class 7 investment products are almost exclusively suitable for investors with extensive expertise and experience. These are speculative investments with the highest risk, which can go beyond the potential returns and quickly lead to a total loss. Examples of such speculative investments are hedge funds, third-country funds or sector funds.

Yes, higher risk classes give you the opportunity of higher returns. At the same time, however, there is also an increased risk that these positive potential returns may become negative and result in losses for you. The potential of higher return expectations for your investment can therefore develop both positively and negatively – the higher the risk, the faster the investment can become a loss.

The SRRI (Synthetic Risk Reward Indicator) is an evaluation indicator that allows investment funds to be divided into five different risk groups:

• Very low risk
• Low risk
• Medium risk
• High risk
• Very high risk

SRRI calculates the historical fluctuations in the fund share price and classifies them by amount in an SRRI category from 1 to 7. In this way, it theoretically does not classify investment funds by a possible risk, but assesses the individual fund historically, i.e. develops a forecast from actual data. 

Investment funds with low price fluctuations receive a low SRRI, which also means that the likelihood of capital losses is low. In contrast, investment funds with a higher SRRI are among the funds with a higher risk, as there are greater fluctuations in value here and thus the risk of loss also increases. 

The SRRI is based on the volatility of the respective investment fund. Volatility indicates the fluctuations that have occurred in the last five years of the returns performance. For example, a volatility interval of 1.5% means that the fund’s value has fluctuated up or down by up to 1.5% in each of the last five years. This would give the fund an SRRI of 2 and would therefore be classified as an investment fund with a risk level of 1 (low risk). 

However, you should always exercise caution when investment fund risk is classified using SRRI. Since the calculation is based exclusively on historical data, it is not possible to make predictions for the future performance of investment funds using the calculated values. An investment fund in risk category 1 therefore does not constitute a completely risk-free investment; rather, the low SRRI only makes a statement about the risk expectations based on years past.

Source: Committee of European Securities Regulators, quoted from the study ““Risikokontrollierte Vermögensverwaltung auf Basis des Synthetischen Risiko Rendite Indikators“, Universität St. Gallen, 2016” [broadly translated as “Risk-controlled wealth management based on synthetic risk and reward indicators”], University of St. Gallen, 2016

In addition to the classification of investment products into risk classes, there are other criteria that can help you to determine the risks of investment forms and investment instruments. 

1. Default risk: The default risk criterion determines the likelihood that investors will lose some or all (total loss) of their investment. For example, if you invest in equities of a single listed company, the default risk of this investment is comparatively high. This is because there is a realistic risk of total loss if there is a sudden price collapse or insolvency. 
   
   
2. Liquidity risk: Liquidity risk relates to the availability of your invested money. If you opt for a financial investment that ties up your investment amount for a longer period of time, there is a correspondingly high liquidity risk. However, unlike the default risk, the liquidity risk is limited in time, as you have free access to your money at the end of the term at the latest. 
   
   
3. Market price risk: Especially in times of crisis, market conditions can change quickly and share prices can fall temporarily or even permanently. The market price risk determines the risk that the market price of an investment will fall for a certain period of time or even indefinitely and that the investment loses a lot of its value. 
   
   
4. Inflation risk: This is the risk that the income from an investment product will fall below the rate of inflation and thus effectively no longer make a profit. In particular, with the rising inflation of 2022, many forms of investment were affected by this risk in the long term, such as savings books or overnight deposit accounts. This is because, despite a positive return, such investments are subject to inflationary monetary depreciation, so that the profit is always below the current monetary value.  
   
   
5. Exchange rate risk: The exchange rate risk always plays a role when an investment is traded across different currencies, for example by investing in the US stock market. Imagine that you are buying a share at the dollar price and want to sell it after a few months or years, but in the meantime the euro has appreciated sharply and the US dollar has fallen slightly. At this point in time, your share has lost some value as you can currently only sell it at an unfavourable price. In this case, the exchange rate risk indicates how much the loss is due to the current currency differences.

The field of risk assessment when it comes to investments is not always quite clear, but with the differentiation between the different models presented here, you have hopefully already gained a better overview. Perhaps you already know exactly where you want to step in and which investment products are suitable for you. 

However, you do not have to decide on just one risk class: rather, you can also diversify across different risk classes, if your risk appetite allows it. Then you can combine investments particularly focused on safety with investments that tend to focus more on returns and get even more out of your investment amount. Or you can focus more on the income opportunities of higher risk classes and use the stability of the lower risk classes to give your investment a safety cushion.

Protecting your investment against losses is not only achieved through diversification across different risk classes, but also through investments within a risk class. So, for example, if you want to invest in equities, you could diversify your investment by buying equities from different companies and industries. 

However, note that individual transactions often carry costs. Therefore, if you buy in small amounts on the financial market particularly frequently, the resulting fees may have a negative impact on your returns.

Investing in funds can counteract this. This is because you automatically invest in several assets at once – such as with our tangible assets fund klimaVest, which invests in numerous wind power and solar power systems at the same time.

Seven risk classes for traditional investments, five risk groups for investment funds, five criteria for further risk determination of various investment products. The importance of risks on the financial market is great – and the importance of the mechanisms/instruments that make them assessable is also great.

The various risk classes of funds and other investments not only help financial advisers, but also you as an investor to make a sound and well-informed investment decision. After all, there is (probably) no one risk class that is perfectly tailored to you.

So make use of the wide-ranging potential of risk classes. There are many ways that you can diversify your investment either within one or across different risk classes – and let your money work in the best way for you.