This is Part 2 of my blog series “Investing 101,” where we look at the importance of understanding risk and return. In the last post, I talked about the importance of discovering your WHY when it comes to investing.
Asking yourself WHY you want to start investing will reveal your financial goals, motivations and time frames for investing. These inputs all form the backbone of your investment plan and give you direction.
Thinking about your ‘end game’ is important because it puts the goal posts down somewhere. You need to know where you want to end up – before you know which way to step first right?
Once you know your goals – the next step is to understand the basics of investing.
Before you even start to look at WHAT you will invest in (which shares, bonds, funds etc.) – you need to understand some basics about HOW the market that those investments operate in works.
To use another car analogy, if you want to drive – you don’t just buy the car and hit the road. You have to learn the road rules first.
Understanding risk and return
It’s important to understand investment risk and how it relates to investment returns. People often refer to this as the risk vs return relationship.
Risk is defined as the chance that an investment’s actual return will be different than expected. Generally speaking, the higher the expected investment return, the higher the investment risk. This can mean the possibility of losing some or all of the money you invest.
Some investments are riskier that others. Some will produce higher returns than others, but a higher return will come with higher level of risk.
Here is a very simple diagram from Money Smart which illustrates this point.
You can see the increase in risk with higher returns across the four major asset classes (being cash, fixed interest, listed property and shares). We will talk more about these asset classes further along in the blog series. What’s important here is to note that the higher the expected return, the higher the associated risk.
But offsetting your investment risk is not as simple as just avoiding the risky end of the assets scale altogether by opting for the lower but less risky investment options like cash.
See the other big point that’s often overlooked is that certainty brings its own set of risks. While you have the advantage of being certain of your bank balance from day to day if you invest in cash you’re also running the very high risk that the value of your money will be lost to inflation.
Over short time periods this isn’t a big deal. But over long periods of time it matters a lot. This is the biggest reason why people suggest that long-term investors put their money into “riskier” investments. It’s very difficult (neigh impossible) to ‘save’ your way to a comfortable retirement even before you factor inflation in. So it’s important to be aware that there are risks at both ends of the spectrum. Generally speaking we all need to take on ‘some’ investment risk in order to reach our financial goals.
As Robert Arnott said “In investing, what is comfortable is rarely profitable.”
Understanding your risk profile
Once you understand risk and return – understanding where you sit on the risk-taking spectrum is fundamental to determining how to invest your money.
What is your appetite for risk in light of the above?
We all have different attitudes towards investing risk. Think about how comfortable you are with the possibility of losing money, what your timeframes are and how you emotionally deal with volatile (up and down) returns. If you would be losing sleep at night over it – you’d probably be taking on too much risk. So you need to consider investments that balance your appetite for risk with their ability to reach your financial goals.
This is a decision that is very specific to you but it is an important one as you want to able to sleep at night. Only you can determine your ‘sleep at night’ factor.
Free Risk profile tools
Here are two free risk profile tools that will give you an indication of your appetite for risk and help you decide how much investment risk you should take on when selecting possible investments.
Mitigating Investment Risk
Some risks are unavoidable – some however can be offset.
Now that you understand the basics of risk and return – it’s important to understand how you can offset that risk. And you can manage investment portfolio risk in part with diversification.
What is diversification?
Diversification is basically the opposite of ‘putting all your eggs in the one basket.”
By allocating your money to a variety of investments you effectively reduce your exposure to any one particular asset or risk.
That way, if one investment doesn’t do well over a certain timeframe, other investments in your portfolio may perform better over that same period, reducing the overall losses of your investment portfolio.
Basically, it has a ‘smoothing out’ effect on your total returns over any given period.
Diversification matters because it is probably the only way you can decrease your risk without decreasing your return.
Let’s look at it another way. The logic is pretty simple. If you only own a few shares, then your return is highly dependent on the performance of those few shares. But if you own the shares of hundreds of companies, then no single company can have too big an impact on your overall returns because it represents a much smaller share of your overall portfolio.
A good way of managing risk with diversification is to spread your money between different asset classes such as cash, fixed interest, property and shares.
Give it to me straight – plain and simple you say?
To tie this all together for you – there are higher and lower risks associated with higher and lower returns across all investment classes (see the diagram above).
If you invest all your funds into a single investment, you are exposed to investment risk.
At the higher end of the scale you are exposed to the potential of higher losses and at the lower end of the scale you are exposed to the risk that inflation will outpace your expected returns and that you may not achieve the returns necessary to meet your financial goals.
You can offset or decrease these risks, by diversifying your investment across all of those asset classes.
That way, your exposure to the poor performance of any particular investment is limited to a smaller percentage of your overall investment and you are still exposed to the potential for higher investment returns.
It’s a win win; and that’s why diversification is often referred to as the closest thing to a “free lunch” in investing.
Your take out?
Work out how you as an investor feel about risk. Answering various risk profile questionnaires (I have provided you with some examples above) will start to give you a feel for how certain levels of risk ‘sit’ with you.
Getting to know who you are as an investor is all part of the puzzle and the journey to becoming a confident one. More on that in the next post!!