How To Manage Investment Risk
Whether you’re a seasoned pro or just starting on your investment journey, understanding how to protect your portfolio when times get tough is absolutely essential. With markets constantly moving, the possibility of big gains—or significant losses—is always looming.
Understanding Volatility
What is market volatility? At its core, volatility refers to the rapid, and often unpredictable, swings in asset prices. And while volatility is a natural part of investing, it can cause a lot of anxiety—especially during times of economic uncertainty, like recessions or political instability. In the UK, for example, factors like interest rate changes from the Bank of England, currency fluctuations driven by geopolitical issues, and global economic trends all contribute to market volatility.
This means investment portfolios could see sharp rises and sudden drops in value. But—and here’s something important—volatility is not always a bad thing. In fact, it can create incredible opportunities, allowing you to buy into undervalued assets and potentially achieve higher returns over time. The key is understanding your own comfort level with risk—what we call your risk tolerance—and adjusting your investments accordingly.
For instance, if you’re someone who has a higher tolerance for risk, you might be comfortable investing in more volatile equities, also known as shares, with the expectation of greater potential rewards. But if you’re a bit more conservative, you may prefer bonds or lower risk funds, which tend to offer more stability. And keep in mind, different types of assets respond differently to market volatility. Equities, for instance, can experience sharp swings, while bonds usually stay more stable.
Another method for reducing volatility and smoothing investment returns is by way of making regular investments. We’ve explored this further here.
Diversification - The Golden Rule of Risk Management
Now, let’s talk about one of the golden rules of risk management: diversification. This involves spreading investments across different asset classes, sectors, geographical regions, and even currencies. The goal is simple: by ensuring a portfolio isn’t overly concentrated in any one area, you reduce the risk that a poor-performing investment could drastically affect the overall portfolio.
what does a well-diversified portfolio actually look like? It could include a balanced mix of global equities, government and corporate bonds, real estate, and commodities like gold or silver. What makes this so effective is that each of these asset classes behaves differently under various market conditions—especially during times of volatility.
Equities, for example, are generally seen as higher risk because their value can fluctuate quite dramatically in the short term. However, they offer substantial growth potential over the long haul. On the other hand, bonds—especially UK government bonds, or gilts—are considered safer investments, offering fixed returns and greater stability. Real estate provides the dual benefits of potential capital growth and steady rental income. Commodities like gold often act as a safe-haven asset during market downturns, helping to preserve wealth when other investments may be losing value.
Let’s imagine a scenario where the UK economy is struggling—maybe due to rising inflation or consumer confidence taking a hit. In such a situation, domestic equities might suffer, but if you’ve also invested in international markets or bonds, those assets may still perform well. For instance, US stocks or emerging markets could be experiencing different economic conditions, offering you some protection. Likewise, government bonds or assets like gold could rise in value as investors seek safer places to park their money.
This balance across different asset classes is what makes diversification so valuable. It ensures that if one part of a portfolio is underperforming, another part might be holding steady—or even thriving. And importantly, when markets recover, a diversified portfolio gives the best chance to participate in that growth, whether through equities bouncing back, bonds providing steady income, or commodities appreciating in value.
In the UK, diversification can also come with some significant tax advantages. By holding a mix of assets in tax-efficient accounts like ISAs or pensions, you can shield gains from capital gains tax and benefit from tax relief on pension contributions. During volatile times, when market gains might be harder to come by, protecting returns through tax efficiency becomes even more crucial.
Time In The Market vs. Timing The Market
In volatile markets, many investors attempt to time the market—selling when prices drop and buying when they rise. But, and this is a big but—time in the market is far more important than timing the market. The longer you stay invested, the more likely you are to benefit from market recoveries and long-term growth.
Consider a hypothetical UK investor, Sarah, who in March 2020 saw the COVID-19 pandemic cause markets to plunge. Panicked, she sold her investments at a loss, thinking she could buy back in when the market recovered. But the markets rebounded quicker than she expected, and by the time she reinvested, she had missed out on a 20% market gain.
If she had simply stayed invested through the downturn, she would have not only recovered her losses but also gained more. By trying to time the market, Sarah ended up costing herself returns and triggering unnecessary capital gains tax on earlier profitable trades. The lesson? It’s best to stay invested for the long haul.
Rebalancing Your Portfolio
A crucial but often overlooked strategy for managing risk during market volatility. Over time, as certain assets in a portfolio perform better or worse, the balance between different investments may shift. For example, if equities perform well, they might start to dominate a portfolio, leaving it exposed to more risk than initially intended.
Rebalancing is the process of restoring a portfolio to its original asset allocation, ensuring that investments stay in line with a risk tolerance. This typically involves selling some of the overperforming assets, and reinvesting those proceeds into underperforming ones. This brings a portfolio back to a desired risk level, keeping things balanced and aligned with financial goals.
Let’s say you’re targeting a 60% equity, 40% bond portfolio. If equities have a great year and now make up 70% of a portfolio, you’re taking on more risk than you initially planned for. By rebalancing—selling some of those equities and buying more bonds—you’re reducing the risk and ensuring a portfolio remains diversified.
A word of caution for UK investors: be mindful of the tax implications when rebalancing, particularly if you're selling investments held outside tax-efficient wrappers like ISAs or pensions. If you sell investments that have appreciated in value and the gain exceeds your Annual Exempt Amount, you could be liable for Capital Gains Tax (CGT), which is taxed at either 10% or 20% depending on your tax bracket.
Using Safe-Haven Assets And Hedging Strategies
Another effective approach during volatile markets is to use safe-haven assets and hedging strategies to protect a portfolio. When markets are turbulent, many investors seek out assets that are less sensitive to market swings—assets like government bonds, gold, or even holding cash. These can provide a buffer of stability when the rest of a portfolio is exposed to riskier investments.
For UK investors, gilts—UK government bonds—are a classic safe-haven asset. They are considered low risk because they are backed by the UK government, and they can provide steady returns when equity markets are in turmoil. Cash, while not a growth asset, offers liquidity, giving the flexibility to take advantage of future opportunities without exposure to further market volatility.
Now, for those looking for more advanced strategies, hedging is an option worth considering. Hedging involves using financial instruments like options or futures to offset potential losses in a portfolio. For example, if you’re concerned about a specific stock in a portfolio losing value, you could purchase a put option—which gives you the right to sell that stock at a predetermined price. If the stock falls, you can exercise the option, effectively limiting losses.
It’s important to note that while hedging can help manage risk, it comes with its own set of costs and risks. Not every investor will be suited to this approach, and in the UK, any gains from hedging strategies could be subject to Capital Gains Tax. As always, you’ll want to factor in the potential tax implications before adopting more complex investment strategies.
Final Thoughts
It’s crucial to remember that volatility is a natural part of investing, and while it can be unsettling, it also creates opportunities. With the right strategies, you can mitigate the risks and take advantage of market recoveries when they occur. And of course, always ensure an investment strategy aligns with financial goals and a risk tolerance. Don’t forget the power of tax-efficient wrappers like ISAs and pensions to help protect and grow wealth, especially in times of uncertainty.
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No financial decisions should be taken based on the content of this website or associated videos. The guidance contained within this website is subject to the UK regulatory regime and is therefore primarily aimed at viewers in the UK. Always take full individual advice first. Regulations and legislation governing taxation, investments and pensions may change in the future.
The content on this page is accurate as of the 2024-25 tax year.