Step 4: Understanding risk

What we’ll cover:

1. Investing can be low risk over a long time period
2. Short term volatility doesn’t matter if you are investing for a 10 year goal
3. Understand your own comfort zone

What is risk?

If our aim as investors is to generate good, inflation-beating returns on our investments that make us wealthier, then there are two main types of risk as we see it.

• Risk Number 1: The risk that at the end of our investment time horizon, the value of our investment might not be as high as we would like (or potentially, even lower than the original amount invested).
• Risk Number 2: The risk that along the way at any moment in time, the value of our investments might reduce to an uncomfortable level.

Your level of comfort for each of these two risks comes together to make up your risk appetite. Defining your risk appetite is incredibly important as it will affect how you should appropriately construct your investment portfolio to cater for your objectives and tolerance for risk in the short and long term. (more on this in Step 7).

Before we get too far ahead, lets talk about these 2 risks a bit. Firstly, investing comes with some risk attached to it. The investor is willing to part-own a company (by buying shares in the company) with the expectation that it will prosper and the value of the company (and their investment) will increase over time. Of course though there are no guarantees, and the recent market crash due to the Covid 19 pandemic is an extreme example of how we cannot always predict how the future will play out.

The trouble is that nobody likes to lose money. In fact, human behaviour means that typically we are more afraid of losing money than we are of not making money. This is understandable. We go to work each day, work hard, look forward to the end of the month to get paid, and enjoy having a bit of money left over once we have paid our bills. The idea of losing some of this hard-earned cash doesn’t sound very appealing. We get it.

This fear of losing money can be pretty unhelpful if you are an investor though. It means that many people might avoid investing in the stock market altogether (this is devastating to your ability to grow your money over the long term). It also means that people who are invested in the stock market can get tempted into selling their investments when they are worth the least. This is also deeply unfortunate.

If you are thinking to yourself that you are absolutely not comfortable with idea of loosing any money, then its worth bearing in mind that even not investing in the first place and instead opting to put your money into a bank account still doesn’t eradicate risk number 1. The trouble is that inflation will eat away at the buying power of your savings, and at the end of your investment time horizon your account balance (almost certainly) will be worth less than the value of your initial deposit. Our opinion is that this is VERY high risk as it is a strategy almost certain to fail to meet our aim of getting wealthier.

What we can do as investors is:

• Understand our appetite for risk (how comfortable we are with the possibility of loosing money, in return for the possibility of making some money).
• Take steps to manage our exposure to risk to suit our risk appetite.

Lets consider first our appetite for Risk Number 1. We all want the value of our investments to increase in the long term (that’s our aim), but each of us might have different expectations for the size of the gain. Some people will be satisfied with preserving the value of their investment (after inflation), others will want large ‘market beating’ investment returns. Each of these two extremes comes with a different appetite for risk. The ideal scenario of high returns with zero risk doesn’t exist (unfortunately).

Our risk appetite should be linked to why each of us are investing and for how long. If you are in your twenties and are investing with a 40 year time horizon to fund your retirement, then you should (we think) be seeking high long-term returns and be comfortable with the associated higher risk that you might not achieve this. There are plenty of years ahead of you to adjust and correct your plan if your investments do not pan out the way you had hoped. On the other hand if you are within a few years of retirement it’s unlikely you would be able to stomach losses as this could impact your standard of living, even if it meant missing out on the potential for higher investment returns. You would therefore have a lower risk appetite.

Everybody’s situation is different, and your own past experiences or those of others close to you are likely to have a bearing on how you feel about risk vs reward. Try to think objectively when you consider the correct appetite for investment risk that you should be taking based on your circumstances. You could consider:

• whether you are relying on returns from your investments to pay ongoing expenses
• whether you are investing some or all of your spare, disposable income
• your investment goals, and whether a range of outcomes is okay
• your investment time horizon

In Step 7 we will provide guidance for how typical investment portfolios could be structured for different levels of risk appetite.

Now let’s consider Risk Number 2. In Step 3 we talked about how statistically the stock market performs well over the long-term, and so if your investment goals are all long term, you can put your feet up and not worry about how your investments are performing on a day to day basis. This all sounds great (and really simple). And it is this simple! But it doesn’t always feel so great if you are watching your investment account value creep (or tumble) downwards over a period of days, weeks or months.

The value of investments rarely change in a straight line over time. Valuations usually wobble upwards and downwards based on all kinds of factors. The trouble is that sometimes the wobbles can get quite big, and at the time falling investment valuations can be quite concerning to investors.

The general tendency is that investments that do well in the longer term can be more volatile in the shorter term. Therefore your risk appetite for long term returns vs losses also needs account for how you will behave along the journey when your investments experience volatility.

Successful investors understand:

• investments should do well over a long time horizon.
• there will be some volatility along the way and this will cause the value of their investments to temporarily fall (they will expect this to happen, rather than be surprised when it happens).
• selling their investments due to short term volatility is usually a very bad move.

Despite the above sounding pretty straightforward the reality is that some people forget that they are invested for the long term and become uncomfortable with short term volatility. This can be dangerous as it can lead to selling when investment values are low, or buying when investment values are high. Both can be very costly for your long term returns. You should consider where you sit between the below extremes:

• You would be deeply troubled by reductions in the value of your investments and likely to lose sleep, worry and/or panic.
• You are ‘laser focused’ on long term investment gains and would be unfazed by short term reductions in value, regardless of the how far prices fall.

Bringing it all together

It’s worth really doing some soul searching to decide how comfortable you are with long term and short term risk. Doing this is about predicting how you will behave in future situations. If you set up an investment allocation based on a very high-risk tolerance, but ultimately panic when the stock market wobbles (or falls), then your investment account is likely to do badly.

Knowing your risk tolerance and using this to determine your investment allocation is about making a plan that is in your best interests and sticking to it if things get dicey.