Taking the Right Amount of Risk
There’s no such thing as a risk-free investment, but it’s important to find the right level for you, writes Martin Hawes.
20 September 2023
You can never completely avoid risk … nothing ever happens without someone taking on risk.
This is true whatever the endeavour, from the most mundane (going and getting the groceries) through to high finance, there is risk. We can try to reduce or mitigate risk, but we can never entirely prevent it.
Most people know this principle applies to investment. All investments have risk; there is no such thing as a risk-free investment. Investors are paid to take risk; no risk means no returns.
Risk and return are twins; you cannot have one without the other. Investors need to be sure they take the right amount of risk and that they are properly rewarded for the risk taken.
I think investors should think of investment risk being either permanent loss or temporary loss. Obviously one of these is a lot worse than the other – most of us can tolerate some temporary loss, but few can manage permanent loss.
A single asset (e.g. one stock on the share market, a business or a rental property) has a greater chance of permanent loss than a diversified portfolio which contains hundreds or even thousands of different companies. However, you should be aware that even a well-diversified portfolio has the possibility of permanent loss. This is not because all those hundreds or thousand of companies may go broke – that has virtually no chance of happening.
However, that well-diversified portfolio could give permanent loss if you sell at the wrong time. Such sales can turn temporary loss (caused by volatility of the markets) into permanent loss.
Temporary losses happen all the time for investors. Markets are volatile; they go up and they go down, sometimes on a minute-by-minute basis. Few investors worry about the small short-term ups and downs. It is when that big slump comes along and their investments are down 20 per cent or more that some people start to worry. Worse, when a major slump happens, the media starts to talk doomsday – there is a wall of negative noise and it can seem like the world is about to collapse into Armageddon.
In fact the most common cause of permanent loss is when people are rattled out of their investments by a major slump. This slump can cause fear (or even blind panic) and many find they have been taking more risk than they can tolerate. That causes some to sell.
We may know that we are supposed to buy in gloom and sell in boom, but many people do precisely the opposite. They buy when times are buoyant and the market’s humming along and sell into a slump. In doing so they are buying high and selling low and as such may show losses on their investments.
A good example of this was with KiwiSaver in 2020. In the Covid share market fall thousands of people reportedly moved their KiwiSaver accounts to less aggressive settings, from (say) a growth fund to conservative. In effect these people found they have a lower tolerance for risk than they thought they had. They have been diversified but have not assessed their risk properly and, inevitably, a slump finds them out.
Selling like this makes their losses permanent. When they go from a growth fund to a conservative fund they are effectively selling some of the shares that are in the fund. That means they did not own enough shares when the slump abated and the markets went back up. They could not make good their losses and selling made their losses permanent.
So, recognise that you will have risk; markets will be volatile and there is nothing that investors or the people who manage funds can do about that volatility.
You need to take risk and, of course, the greater the risk you take the higher the returns you should expect (investors are rewarded for risking their money). Remember, selling into a slump is bad. It turns a temporary loss into a permanent one.
The only thing you can do is have investments that have the right amount of risk, an amount that you can tolerate. It is important you let a tolerable amount of risk set your investment strategy rather than set the strategy by the returns you want.
The most important thing you can do is assess your tolerance for risk before you start to invest. There are many risk calculator apps available. The website Sorted has one and many KiwiSaver providers have them on their websites. Spend a few minutes filling in a simple form that will tell you your tolerance for risk, and how you should invest.
Martin Hawes is a financial author and speaker. He is not a Financial Advice Provider nor a Financial Adviser. The information contained in this article is general in nature and is not intended to be financial advice. Before making any financial decisions you should consult a professional financial adviser. Nothing in this article is, or should be taken as, an offer, invitation or recommendation to buy, sell or retain a regulated financial product.
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