Investing inherently involves risk, and gaining a comprehensive understanding of the various types can enhance your effectiveness as an investor.
What is Investment Risk?
Investment risk refers to the likelihood that the actual performance of your investments will differ from your expectations. In simple terms, it quantifies the chance that your returns may be higher or lower than anticipated.
Without risk, there would be no potential for additional returns; it is a fundamental component of investing. However, taking on investment risk also means accepting the possibility of losing some or all of your initial capital.
Investors exhibit varying risk tolerances. Higher-risk investors accept a greater chance of loss for the potential of higher returns, while lower-risk investors may choose to forgo higher returns in exchange for a reduced chance of significant losses.
Finding the right balance is crucial. Being too conservative or overly aggressive can affect your long-term investment strategy. This is why we evaluate your risk level upon joining Nutmeg and conduct annual reviews.
Your risk profile encompasses your risk appetite, risk tolerance, and investment time horizon. This profile ultimately shapes the composition of your portfolio and its expected performance.
For those with a low risk tolerance and a short investment timeframe, we may recommend a portfolio weighted toward fixed-income assets. Conversely, if you have a low risk tolerance but plan to invest for a decade or longer, we might suggest a more balanced portfolio that offers greater growth potential.
Once you’ve identified your risk level, it’s our responsibility to understand and manage the risks within your portfolio to provide sustainable long-term returns.
Types of Investment Risk
Investment risk can be categorized into several types:
- Absolute Risk: This refers to the prospects of gains and losses associated with your portfolio and is closely tied to your long-term risk profile. For example, a fully equity-based portfolio will differ significantly in terms of expected long-term returns and volatility when compared to a balanced or fixed income portfolio.
- Relative Risk: This measures the potential for gains and losses compared to a benchmark or peer group. While relative risk fluctuations are typically less pronounced than absolute risk, they often help differentiate effective managers from less effective ones. For instance, if an equity portfolio generates a 6% return while its benchmark achieves 10%, it reflects poor relative performance despite both being positive.
- Systematic Risk: Also known as market risk, this encompasses factors that impact the entire market and cannot easily be mitigated through diversification. Examples include macroeconomic characteristics such as inflation and interest rate fluctuations, along with unexpected events like the COVID-19 pandemic, classified as ‘black swan’ occurrences due to their rarity and potential severity.
- Idiosyncratic Risk: In contrast to systematic risks, idiosyncratic or unsystematic risks impact smaller, localized areas such as specific assets, regions, or companies. These risks can often be reduced through diversification. For example, an investor seeking exposure to emerging market equities might choose funds that cover the entire market rather than investing in a single country.
Current Risks Facing Investors
Investors constantly encounter risks, which may seem daunting. However, to achieve returns that surpass what cash savings can offer, one must embrace a certain level of risk.
Risk inherently creates opportunities and momentum in the market. Divergent perspectives among investors contribute to the supply and demand of assets, resulting in both gains and losses. If everyone unanimously agreed on market conditions, trading would stagnate.
Currently, several systematic challenges confront the economy. Elevated core inflation, tight labor markets, and rising interest rates have influenced various market sectors over the past 18 months. Geopolitical risks also loom large, as demonstrated by the repercussions of the Russian invasion of Ukraine, affecting numerous aspects of the global economy.
Regarding unsystematic risks, the possibility of a recession in the U.S. could adversely impact developed market equities. Additionally, bonds face heightened credit risk, reflecting the potential for loss if borrowers default on loans, particularly in the context of rising interest rates.
How We Manage These Risks
Managing investment risk is central to our investment process.
In constructing and monitoring our portfolios, we prioritize mitigating absolute risk and managing relative risk to ensure optimum long-term performance for our clients.
We adhere to a framework called Modern Portfolio Theory (MPT), embraced by investment managers worldwide. MPT posits that investments should be chosen and combined to maximize overall returns while effectively managing risk. This strategy underscores the importance of diversified portfolios that blend various asset classes in order to achieve returns within acceptable risk limits.
In developing our portfolios, we are mindful of factors such as concentration, illiquidity, opacity, and complexity—the ‘5 sins of investments’ that signify absolute risk or potential permanent loss of capital. Our goal is to create portfolios that minimize these risks while offering attractive long-term risk-reward profiles.
This approach ensures our portfolios have a diversified spread across asset classes, are rebalanced regularly, and invest in thoroughly researched ETFs selected based on criteria including size, trading volume, and liquidity. One key advantage of using ETFs is their transparency, allowing us to continuously evaluate portfolio risks.
In managing relative risk, we consistently compare our portfolio positioning to that of relevant benchmarks. Our macroeconomic insights, along with historical data and portfolio analysis, guide our forward-looking risk management strategy.
While some investment risks are personal, others apply universally. Our role is to help you navigate both sides.
We aim to ensure that you invest in a portfolio aligned with your risk tolerance for the medium to long term, helping you stay within those parameters throughout your investment journey.
For our latest insights on market trends and portfolio performance, click here.
Risk Warning
As with all forms of investing, your capital is at risk. The value of your Nutmeg portfolio may fluctuate, and you might receive less than your original investment. Past performance and forecasts are not reliable indicators of future results.
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