Understanding investment risk

Look it up in the dictionary and you’ll see that risk is described as a situation involving 'exposure to danger'.

1. What is risk

Not the most inviting of propositions. But when looking at risk in terms of investing, fear needn’t be a factor.

Truly understanding risk as a concept is simply a cornerstone of successful long-term investment management.

Risk describes the uncertainty of the returns on an investment. It is an indicator of the potential for losing money and making money. Although we often do not think of it this way, it can mean returns are unexpectedly high.

Different investments will be more or less risky. Shares are considered more risky than bonds, although this is not true for individual shares and bonds. Investments that are more likely to give higher returns in the long run may have a bumpier ride along the way, whereas investments with a lower return potential are often more likely to remain steady and stable for the duration.

Put simply, investments that have higher risk usually have higher rates of return. So, individuals who are looking to increase the value of their investments significantly, and who are prepared to accept that the value of their investments might fall, are more likely to choose to invest in assets that have high risk.

No single asset class can be relied upon to produce safe, reliable and consistent returns. At Nutmeg, we believe that a diversified investment portfolio — with an appropriate proportion of cash, equities, bonds, property, commodities and alternative asset classes for your goals and risk tolerance — is a better way to maintain and build wealth over the long term.

Some examples:

Portfolio composition Best year return Worst year fall Worst 12 months
Low risk 100% 0–5 Year Gilts 1998 +11.4% 2013 -0.8% -0.9
Medium risk 50% Gilts, 35% FTSE All Share and 15% MSCI All Share ex UK 1997 +18.6% 2008 -8.3% -14.5%
High risk 30% FTSE All Share and & 70% MSCI All Share ex UK 1999 +30.1% 2002 -26.0% -31.1%

2. How you feel about risk

Nobody really likes risk, but some are more able to tolerate it.

Knowing how you feel about risk is the first step in determining what sort of portfolio of investments is right for you. This is important as you need to know that you can stay the course if your investment falls in value, as it almost certainly will from time to time. Also, if your portfolio is too cautious, you may be disappointed in the returns you get.

At Nutmeg we help people with a well established and rigorously tested risk assessment. By answering ten questions, you can establish your attitude to risk which will help you understand how you feel about investment risk and determine what the right investment strategy is for you.

quotation marks
“The stock market is a device for transferring money from the impatient to the patient.”

— Warren Buffett, CEO of Berkshire Hathaway

3. How much can you afford

The question is what would it mean for your if your investment fell in value? The above table gives some idea of what has happened in the past.

Give some thought to how it would affect your plans and your standard of living.

If you have flexibility about when you need your money, you can leave the money to recover from a downturn. How long that takes has varied widely from a few months to a few years, and will also depend on how it is invested. This is a very good way of managing risk, but requires the financial and psychological ability to delay encashing your investment.

At Nutmeg we show you what the downside may look like so that you can really think about what that would mean for you.

4. Your investment goals

Even leaving money in the bank involves some risk, that of inflation.

Sometimes people have a general idea of what they want from their investments, for example to keep up with inflation, or to preserve their capital.

People may also have a more specific goal, such as to build a pot of £10,000 in ten years time to fund a dream holiday. It is important to know whether that is realistic given the risk strategy, contributions and time frame. We help you understand this with our projections which you can access any time by editing the risk level on one of your Nutmeg pots.

If you are going to fall short, rather than change the amount of risk, we will suggest changing your contributions or extending the timeframe. You can also reduce the amount you are aiming for.

Alternatively if you are going to overshoot your objective you can reduce your contributions, dial down the risk or bring forward the timeframe.

Risk warning. As with all investing your capital is at risk. Past performance is not an indicator of future results and future returns are not guaranteed.

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