We all know that investing carries risk. Understanding the different types can make you a better investor.
What is investment risk?
Investment risk is broadly defined as the chance that the actual performance of your investments will differ from the expected performance.
In other words, it’s the chance that your return is more or less than you anticipated.
Without risk, there would be no additional returns. It is an essential part of investing.
But taking on investment risk also means accepting the possibility that you could lose some or all of your initial investment.
We all have a different tolerance for risk – if you’re a higher risk investor, you take on a higher chance of losses for the possibility of higher returns. If you’re lower risk, you accept the possibility of lower returns for a smaller chance of significant losses.
It’s incredibly important for investors to be comfortable with this trade off and find the right level of risk, as being too cautious or too risky can impact your long-term strategy. This is why we assess your risk level when you join us, and annually thereafter.
Your risk level is determined by your risk appetite, risk tolerance, and time horizon. This is because your overall risk level determines what goes into your portfolio – and how it may perform.
If you have a low tolerance for risk, and are investing for a relatively short timeframe, we may suggest you select from the lower end of our risk range – a portfolio mostly made up of fixed income assets. But if you have a low tolerance for risk and plan to invest for a decade or more, we may suggest something nearer the middle of our range, so your investments have the chance to grow appropriately during that timeframe.
Once you’ve chosen your risk level, we are then responsible for understanding and managing the risks facing your portfolio to give you the possibility of sustainable long-term returns.
But what do we mean by this – and how do we do it?
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 full equity portfolio will have different expectations in terms of long-term return and volatility than a mixed portfolio or a full fixed income portfolio, for example.
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 manager from a bad one. For example, if an equity portfolio generates 6% in a year when the benchmark it is following 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. For instance, if an investor wants exposure to emerging market equities, they may choose funds that give them access to the whole market, rather than investing in one country.
What are the main risks facing investors right now?
Investors are always facing risks.
This might sound a little unnerving. But remember that, to achieve returns beyond what cash savings can provide, investors must be willing to take on some risk.
In fact, risk creates opportunity and momentum within the market. Different investors have different perspectives at different times, and this helps drive the supply and demand of assets, which generates losses and returns.
If everyone shared a consensus about what was happening in the world, then the market would grind to halt.
On the systematic side, the economy is facing several challenges, which we’ve often spoken about in recent months. Stubborn levels of core inflation and tight labour markets along with higher interest rates have touched almost all corners of the market in the last 18 months. Geopolitical risk remains ever present, as investors will remember well from the market impact of the Russian invasion of Ukraine and its consequent impact on many aspects of the global economy.
Now to unsystematic risks. For developed market equities, the possibility of a recession in the US could impact performance. For bonds, credit risk (the possibility of loss if someone defaults on a loan) is likely to become elevated as the impact of higher interest rates continues to be felt.
How are we managing these risks?
That’s an excellent question.
Investment risk is key to our investment process.
When building and monitoring our portfolios, we focus on mitigating absolute risk and managing relative risk – as long-term performance is crucial for investors.
We observe a framework known as Modern Portfolio Theory (MPT), which is used by investment managers across the world. At the core of MPT is the idea that investments should be selected and combined in a way that maximises overall returns while managing risk. It suggests that constructing diversified portfolios that contain a blend of different asset classes is one of the best ways for investors to achieve returns while staying within their risk level.
When we build our portfolios, we are thinking about concentration, illiquidity, opacity, and complexity. These five factors are the ‘5 sins of investments’ that embody absolute risk or the potential for permanent loss of capital. We seek to build portfolios that minimise these risks and instead have attractive, long-term risk-reward characteristics.
This means that our portfolios are well diversified across asset classes, rebalanced regularly, and invest in ETFs that have been rigorously researched and selected to meet our standards for size, trading volume, and liquidity. Indeed, one of the reasons we use ETFs is because they are transparent – and allow us to model the risks facing our portfolios day-in, day-out.
When it comes to managing relative risk, we consistently assess our portfolio positioning against that of our benchmark. We use our macroeconomic and market research to manage relative risks on a forward-looking basis, and combine historical risk reporting and portfolio analytics on a backward-looking basis to help guide our decision-making as well.
Some investment risks are highly personal – while others are more universal.
Our job is to help you manage both.
We want to make sure that you’re investing in a portfolio that is taking the right amount of risk for your circumstances over the medium and long-term, and helps you stay within those parameters during the course of your investment journey.
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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 performance and forecasts are not a reliable indicators of future performance.