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.
What is risk in investment?
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 the potential for higher rates of return. So, individuals looking to significantly increase the value of their investments, who 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 (types of investments). Investments that may have greater potential to deliver higher returns in the long run, may also have a bumpier ride along the way. Whereas investments that may have a lower return potential may remain steady and stable for the duration.
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 risk spectrum, 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.
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 may 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.
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 have the potential 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 at Nutmeg
At Nutmeg, our experienced investment management team creates and manages 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 in line with your goals.
Find out more about what we mean by risk.
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. Past or future performance indicators are not a reliable indicator of future performance.
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Stephen Desmond
Stephen regularly contributes to the Nutmegonomics blog - writing about investment and personal finance.Other posts by Stephen Desmond