4. Understand the trade-off between risk and reward

What are the different types of investment risk?

Investment risk can be split into different categories.

Absolute risk is the potential for your portfolio to experience gains and losses and is closely linked to the long-term risk profile of your portfolio. A portfolio that only contains equities may have different expectations in terms of long-term return and volatility than a mixed portfolio or a portfolio that only contains fixed income.

Relative risk is the potential for gain and loss versus a benchmark of what would be comparable peers and competitors. Relative risk tends to diverge less than absolute risk, but is often the way to differentiate a good investment manager from less successful investors. For example, if an equity portfolio generates 6% in a year when the benchmark it follows generates 10%, it will be a poor relative return even if the year has been largely positive.

While absolute risk often makes the headlines, managing relative risk is crucial for long-term investors. If you’re consistently underperforming your benchmark, then this can have a material impact on your long-term returns.

Systematic risk is also known as market risk. These are factors that affect the whole market and cannot be easily predicted nor mitigated through portfolio diversification. These include macroeconomic shocks, inflation, and interest rate risk as well. Events like COVID-19 sit on the far end of the systematic risk spectrum. They are known in the industry as ‘black swan’ events – rare and unpredictable but with severe consequences.

Unlike systematic risks, which affect the whole market, ‘idiosyncratic’ or unsystematic risks affect smaller and more localised areas, like groups of assets, countries, currencies, or individual stocks. They can be mitigated through diversification. 

Your risk tolerance should adapt, but avoid tinkering

Our clients can easily change the risk profile of their investments. However, we strongly recommend investors not to change their risk tolerance on a regular basis. Doing so effectively means selling assets and buying different ones (i.e. timing the market) which, as we previously explained, is not a good strategy, and can also cost money, because of factors such as fund charges and market spread.

There are however situations in which adapting your approach to risk could be wise. You may have experienced a change in personal circumstances that means you are no longer as comfortable with the idea of losing money, for example. If this is the case, it is sensible to seek financial guidance before making any decisions. 

It may also be a good idea to reduce risk exposure in the lead-up to a significant financial commitment. This is so you can help protect yourself against any sudden swings in the market in the short period before you want to use your money.

While you could switch to cash to have less risk of loss compared to investing, another approach may be to decrease your exposure to equities and increase your exposure to bonds, which could provide a steady stream of income and are generally less volatile. 

If you want to buy a home, for example, you may want to reduce the risk that the deposit in your LISA or other investment account drops below a certain amount, as otherwise you may need to borrow more to make your offer.

Get comfortable with volatility

Volatility is a measure of the change in value of an asset. When volatility is high, it is an indication that values are changing more sharply and quickly than usual. The value of all financial markets changes over time, with many asset classes such as equities and bonds (which make up our ETFs) changing in value throughout the day as parts of the intertwining cogs of the wider financial system.

Volatility can cause changes in how confident investors are about the prospects for different types of investments, often referred to as ‘investor sentiment’. If a policy change is announced that many investors deem negative for the prospects of an asset class, investor sentiment for those assets can fall quickly and sharply.

But it’s important to get comfortable with volatility. If your portfolio is down today, remember that a loss is only locked in when an investment is sold. Although an investor may see their portfolio value move around more quickly than normal during a period of heightened market volatility, that same portfolio may not be down in value in a month’s time, or by the end of the year.

If you’re not comfortable with short-term fluctuations in the value of your investments, you may be more risk-averse than you thought. It might be worth seeking out guidance or advice, and reassessing your financial objectives and the risk that you've taken on in your portfolio. But if your time horizon allows, it’s important to give your money enough time to ride out volatile periods.

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Tax rules vary by individual status and may change. Pension, ISA, JISA and LISA eligibility rules apply. With LISAs, govt withdrawal charges may apply. 

Nutmeg does not provide tax advice. For personalised advice tailored to your specific situation please consult with a qualified tax adviser or financial planner. If you are unsure if a pension is right for you, please seek financial advice.

Nutmeg provides 'restricted advice', which means we will only make investment recommendations on the products and services that we offer.