In the first part of this two-part series on risk, we focused on personal risk. In this part I want to discuss investment risk.
What is investment risk?
To a lot of people investment risk is probably not very well understood, so I thought it’s important to start off by describing what investment risk actually means. As you recall, I previously described risk as something that has an uncertain outcome.
So if we define an investment as buying something that has the potential for growth or generating income, then we can define investment risk as the uncertainty associated with that investment growth or return.
Risk vs return
Investment risk is one of the cornerstones of investing. The other cornerstone is expected return, in other words how much growth or income can you expect from a particular investment. Combining these two concepts together is what is referred to as the risk-return ratio - how much investment risk are you taking on for the expected investment return. Typically higher risk implies higher expected returns, but not always.
Although investing is fundamentally about finding the right risk-return ratio that suits your investment goals, personal finances and time horizon, sadly too many people don’t take investment risk into account and simply focus on the size of the return. I mean, who doesn’t want to get rich quick right?
If you had some spare cash, you might consider gambling on a sports bet or buying a lottery ticket because even though it’s high risk (very low chance of winning) the returns can be huge. Sadly though, this is not the case because when you do the maths the expected return is actually very low or negative, as we showed previously.
Not investing carries the risk of losing the value of your money
When it comes to choosing between whether to stick your money under a mattress, put it in a bank account or invest it, it’s good to know what risk-return ratio is right for you and your investment goals. And although your instinct might be to avoid investment risk at all cost, given even the smallest possibility of losing money, the problem with low-risk, low-return options is that very often they fail to outperform inflation. For those who have forgotten or don’t know, inflation is the decrease in the value of money over time and currently stands at 3.2%. What this means is that if you put your money into a bank savings account that offers you 1% interest, it means that in a year’s time, your money will have 2.2% less buying power than it does today. In effect, you would have lost money!
So the real question is how do you minimise investment risk while still ensuring that your money grows and inflation doesn’t eat into your savings. The two key things to consider here are the time horizon of your investment and the diversification of your investment. More specifically, can you afford to wait (for better times) and how can you avoid having all your eggs in one basket. I’ll unpack each of these concepts one at a time.
1. Lowering risk by leveraging time
The reason why time is so important is because in investing, prices can go up and down. Why this happens is because most investments are traded in an open marketplace where the price is determined by negotiation between a willing buyer and a willing seller. The frequency and magnitude of these price swings are referred to as the volatility of the investment. To explain the concept of volatility, let's consider the price of your house and the price of Bitcoin, a cryptocurrency that has become very popular with speculators. It's very unlikely that the price of your house will vary drastically in one day. However, earlier this year the price of Bitcoin dropped by 50% in a day! In comparison, the price of your house or flat can maybe move 10% in a year. Bitcoin therefore has high volatility, compared with property prices.
The most important thing to know, is that if you can afford to hold onto an investment for long enough, you can largely ignore the investment's short term price fluctuations.
2. Lowering risk through diversification
Another common way of reducing your investment risk is through diversification. Although this word may seem complicated, in fact the concept is very simple and is linked to the old saying, don’t put all your eggs in one basket. The reason for this is to spread out different types of investment risk so that by investing in diverse assets, such as property, equity and cash, you reduce your overall risk because the chances of something bad happening to those different asset classes simultaneously is very unlikely.
The second life lesson of investing is diversify your investments. This means spreading your investment risk out over different types of investments.
To sum up, we all want to get rich quick, but remember that wealth can take a lifetime to build and a second to lose. Investment risk is real. Protect yourself against the risks by thinking carefully about the risk-return ratio is right for you and where possible, spread your investments out over different types of investments. Don’t be fooled by people who have gambled and got lucky.