Risky business: Understanding the volatility of investments and potential for returns

Stephen Desmond
on

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

Understanding risk and volatility

What is risk?

Risk describes the uncertainty of the returns on an investment. It is an indicator of the potential for losing money and making money.

Put simply, investments that have higher risk usually have higher rates of return. So, individuals looking to significantly increase the value of their investments, and are prepared for the fact the value of their investments may also go down, are more likely to choose to invest in assets that have high risk.

This is also known as the ‘volatility’ of an investment. It can be measured by looking at the highest and lowest price of an investment over a period of, say, a year. This then gives us an indicator of potential future risk and we can start to draw comparisons between the volatility of different shares, bonds and commodities. 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.

The volatility of investments

What level of risk is right for you?

Understanding risk means identifying your own attitudes towards it and knowing what level of risk you want to take with your investments. We’d all pick the ‘high return, low risk, fast exit’ option if it were on offer, but quite frankly it’s not.

The spectrum ranges from ‘low risk, low return potential’ to ‘high risk, high return potential’. So you need to seriously consider where you place yourself along that curve. It’s crucial to understand that it doesn’t have to be one single point. This is where the importance of your timeframe really kicks in.

Time is money

It may well be that you want to place your money at a few different points along the curve, depending on the kind of investment goal you have in mind – whether you’re planning to accumulate a chunk of money as part of your retirement plans in 25 years or save for your child’s further education in five years.

Understanding risk and volatility of investments and markets

A common myth is that long-term investments are considered slow and cautious, and should therefore be low risk. That’s not necessarily the case. Investors looking at investing for a long period often select a high risk approach because it means their portfolio has a longer time to recover from any price dips and has a greater chance of benefiting from any big price rises over the years. As an investor gets towards the end of, say, a 20-year investment, they may then decide to lower the risk profile of their portfolio because they want to protect the price rises they’ve benefited from, while a sudden drop in valuations could seriously dent their returns – with little time to recover.

Risk profiles at Nutmeg

When you set up a Nutmeg investment pot, you choose the level of risk you’d like to take on a scale of 1 (cautious) to 10 (aggressive). You can set up a number of Nutmeg investment pots and assign different risk levels to each.  And you can change the level of risk if your circumstances change. If you do so, we’ll review your profile to check the allocation of investment assets assigned to your pot is right for you and your long-term investment plans and make any adjustments necessary – all at no extra cost.

Setting your investment risk on your Nutmeg pot

We determine the mix of investment assets that’s right for you based on a number of factors. The level of risk you select is one important factor, of course, but there are others – the amount you want to invest and any monthly contributions you want to make, the length of time you intend to invest for and the target amount you’d like to reach.

Which investment assets are high risk and which are low?

High-risk asset mixes tend to have a bias towards companies in developed and emerging markets that we think are more likely to produce good returns on your investment in the long run but may be volatile. Low-risk asset mixes generally show a bias towards bonds and cash, which are less likely to give big returns but are more likely to remain stable.

So, an investment in bonds issued by a large company in the UK can have far less risk than shares in a small company in a market like Kenya due to there being more established and stable economic conditions associated with it. However, the returns from these different investments may also vary.

Managing risk

We create and manage asset mixes that are spread across a vast range of investment types – shares, bonds and commodities – and across different countries and sectors. This basically means you don’t have all your eggs in one basket, so your money can be better protected from a sudden price drop in one asset and has more chance of benefiting from price rises in other assets. While we will have different asset mixes for low-risk compared to high risk, we will generally make sure your money is invested in at least 10 (and usually more) different types of investment assets to help manage your portfolio and keep it line with your goals.

Find out more about What we mean by risk

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New to Nutmeg?

If you are looking to invest but are not sure where to start, Nutmeg can help. We build an investment portfolio for you based on financial information you provide and your personal attitude to risk. And our online tools are data driven, giving you a clear idea of risk and return. We’re low cost and transparent so you can always see where your money has been allocated and how it’s performing.

Try it out, with no obligation – you can set up a portfolio in just a few minutes

Why Nutmeg? 

Because we’re the way investing should be – intelligent, transparent and low cost. See how we compare

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Risk warning

Capital at risk.

The views and opinions expressed herein are for informational purposes only. They are not personal recommendations and should not be regarded as solicitations or offers to buy or sell any of the securities or instruments mentioned. The views are based on public information that Nutmeg considers reliable but does not represent that the information contained herein is accurate or complete. With investment comes risk. The price and value of investments mentioned and income arising from them may fluctuate. Past performance is not an indicator of future results, and future returns are not guaranteed.

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Stephen Desmond

Stephen Desmond

Stephen regularly contributes to the Nutmegonomics blog - writing about investment and personal finance.

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