Risk ratings help you to better evaluate the risks of investing in a fund. This moneyland.ch guide gives you a clear and concise explanation of what each of the seven ratings means.
When looking at the key investor document (KID) of a mutual fund or exchange-traded fund (ETF), you will normally find a risk level rating with seven different levels. This moneyland.ch guide tells you how to interpret the risk rating, and explains how to determine which risk class is right for you.
What is a risk rating?
Risk ratings give investors a point of reference with which to judge the risk of losing money with an investment product. The risk is shown on a scale of one to seven. Ratings can be found in the key investor document (KID) of the specific investment product, when a KID is provided. A risk rating of one indicates the lowest investment risk, while a risk rating of seven indicates the highest risk of loss.
The risk ratings are based on the standardized summary risk indicator (SRI) system. The SRI, in turn, is part of the European Union’s packaged retail investment and insurance-based product (PRIIP) ordinance, which is also used in Switzerland.
How are the risk ratings determined?
The SRI is based on the investment vehicle’s volatility over the past two to five years (depending on the product). It also accounts for the issuer’s creditworthiness – with the exception of funds, because fund capital is segregated from its issuer becomes insolvent.
The risk rating is always calculated based on a certain recommended investment term – five years, for example. It is important to be aware that the risk can be higher or lower than indicated if you hold the investment for a different term.
Important: Risk and returns are generally linked. Normally, the higher the risk, the higher the possible returns of the investment are. If you only invest in low-risk investments, your returns will usually be correspondingly small.
What does each of the risk ratings mean?
Using investment products with a number one risk rating bears the lowest possible risk of loss. The nominal value of the investment hardly fluctuates, or does not fluctuate at all. The returns you earn are normally also very low.
Examples: Interest-based investment products like savings accounts and fixed deposits (though no KIDs are published for these), money market mutual funds, and money market ETFs.
Suitable for: Investors with very low risk tolerance, and for short-term investments.
The risk category number two also indicates a relatively low risk of loss. The potential returns are normally slightly higher than those of investment solutions with a number one risk rating, and the risk of loss is also slightly higher.
Examples: Bonds from borrowers with exceptional creditworthiness, funds with defensive investment strategies.
Suitable for: Investors with low risk tolerance.
Investments in this category are relatively conservative. But compared to investment vehicles with ratings of one or two, category three investments can potentially achieve higher returns. As a trade-off for higher potential returns, these investments are also more exposed to price fluctuations. Both the risks and returns of investments with a number three rating are moderate.
Examples: Bonds from borrowers with good creditworthiness, funds with mixed portfolios that include both stocks and bonds.
Suitable for: Investors who focus on security, but aim to earn higher returns than they could using conventional interest-based products.
A risk rating of four indicates a balanced opportunity-to-risk ratio. The value of the investment can fluctuate significantly, but over long terms the returns are often substantial.
Examples: Broadly diversified mutual funds and ETFs that invest in the stock market – global indexes, for example.
Suitable for: Investors with a long-term investment mindset who are able to deal with price fluctuations.
Investment vehicles with a number five risk rating are focused on returns. This focus brings with it a relatively high risk of loss, especially over short terms. Both high gains and major losses can occur at any time. Even a total loss is possible, although unlikely.
Examples: Individual stocks, ETFs that invest in specific industry sectors or themes, ETFs that invest in certain countries.
Suitable for: Experienced investors with high risk tolerance who accept the risk of losing money.
These investment products are highly speculative, and have a high risk of loss. A total loss is also possible, but returns can also be very high. Some of the investment products in the number six category are leveraged. This multiplies both gains and losses, and can make them unpredictable for inexperienced investors.
Examples: Cryptocurrencies (including bitcoin and Ethereum), options.
Suitable for: Experienced investors with high risk tolerance who are willing to accept a total loss. These investment vehicles are not suitable for inexperienced investors due to their complexity and risk of loss.
Investment products with a risk rating of seven are highly speculative, and are designed for investors who possess a great deal of knowledge in the specific field in question. The goal of these products is normally to maximize returns, which requires taking extraordinary risks. Many leveraged products fall into this category – as leverage can hugely raise both the potential for gain and the risk of loss.
Examples: Hedge funds, private equity (venture capital, for example).
Suitable for: Highly experienced private investors and professional investors. These products are not suitable for average investors because they are complex and have a high risk of loss.
How reliable are investment risk ratings?
SRI risk ratings can serve as a point of reference for investors by helping you better estimate the possible risks and returns of an investment product.
But risk ratings are not completely problem-free, because they only offer a narrow risk estimate. There are many different factors that play a role in investment risk. The volatility data used for SRI ratings is just one of those factors, and hardly suffices for a detailed assessment of a product’s investment risk.
Important: The opportunity-to-risk ratio is also strongly influenced by the actual amount of time that you remain invested, which may be very different to the recommended term used to calculate the risk ratings shown in the KID. For diversified stock portfolios, it is always advisable to use very long investment terms.
As a general rule, you should always be aware that it is impossible to predict the future performance of investments in advance. Even investment aids like risk ratings are only based on historical data.
Disclaimer: This article is provided for educational purposes only and should not be considered investment advice. The publishers do not accept any liability in relation to this article.
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