Noel Whittaker’s money lesson 101: risk and return

Understanding this concept is a fundamental plank in being money smart.

noel whittaker

Ask a room full of people whether they are confident in their ability to handle money, and the answer may well be yes. Unfortunately, rather than proving their skills, the answer may be an indication that they simply don't know what they don't know.

The main problem is that when deciding where to place their money, few investors take risk and return into account. This is a sad state of affairs, because the two are irrevocably entwined, and an understanding of them is fundamental if you are going to be money smart.

First, understand that it is impossible to find a risk-free strategy. If you leave your money in the bank, you will suffer low returns with the very strong chance that you’ll live longer than your money, because every year its purchasing power will be diminished by inflation. Yet, if you put it in growth assets, such as property and shares, you leave yourself open to capital losses if you make the wrong choices or try to redeem when the market is down. It pays to remember the adage, ‘whenever there is a chance of capital gain, there is a chance of capital loss’.

You might have heard the old saying, ‘the higher the return, the higher the risk’, and you probably understand that higher returns mean you increase the chance of losing your nest egg. True. But to make it more confusing, here’s another saying: ‘the higher the risk, the higher the return’. No, it’s not a misquoting of the original saying, it’s just as true, but refers to a different kind of risk.

In investment jargon, the word ‘risk’ means the degree of volatility of market movement that is associated with an investment. To put it simply, the more the value of an asset fluctuates, the riskier it is said to be. By this definition, cash is a ‘riskless’ asset because $1000 in the bank today should still be $1000 tomorrow, even when property and share markets tumble. In contrast, you can be certain that the value of your share-based investments will vary from day to day but, provided they are well chosen, you will achieve better returns over the long haul to compensate you for the increased risk or volatility.

A geared share trust is a great example. You will get higher returns than the market with a geared share fund because the internal gearing magnifies the gains. The downside is that you will suffer higher losses when the market falls, as they are magnified too. This makes geared funds a good investment for younger investors who have a long time frame in mind, and a mindset that can handle the roller-coaster ride these funds can give.

The lesson in all this is that time is the crucial element when considering where to invest those hard-earned dollars. If you believe you will need to withdraw the money in less than three years, you should stick with safe interest-bearing accounts, such as those offered online by the major banking institutions. They give certainty and no chance of loss.

However, if you are in it for the longer haul, you need to understand the risk-reward concept, because there is no doubt that ‘risky’ investments, such as quality shares, will give the best returns over time.

Think about Jack and Jill who are aged 40 and are saving for their retirement. They both have $250,000 in super now.

They decide they will need an income of $60,000 a year in today’s dollars. This is $125,000 in the dollars of 25 years away.

Jack is an inexperienced and very cautious investor, and is so risk averse that even on optimistic forecasts his superannuation will earn 5 per cent per annum both before and after retirement. Jill understands the risk-return trade-off, and chooses a portfolio that is heavily weighted towards shares – her expected return is 8 per cent per annum.

If inflation averages 3 per cent per annum, Jack will need to accumulate $2.5 million at age 65. This will require monthly contributions of $3300 to superannuation, which is probably well above his capabilities. Because Jill’s investment strategy will provide a higher return, she needs to accumulate only $1.9 million, and has to invest just $415 a month to get there.

This is a graphic illustration of the importance of understanding the risk-return trade-off. As Jill is prepared to accept greater volatility, she has to contribute far less to her superannuation during her working life – consequently, she has more money to spend out of each pay, while at the same time knowing her future is secure.

Has risk been part of your strategy? Are you comfortable with how you are handling your retirement income?

Noel Whittaker is the author of Making Money Made Simple and several other books on personal finance.

If you enjoy our content, don’t keep it to yourself. Share our free eNews with your friends and encourage them to sign up.

RELATED ARTICLES

    Disclaimer: All content on YourLifeChoices website is of a general nature and has been prepared without taking into account your objectives, financial situation or needs. It has been prepared with due care but no guarantees are provided for the ongoing accuracy or relevance. Before making a decision based on this information, you should consider its appropriateness in regard to your own circumstances. You should seek professional advice from a financial planner, lawyer or tax agent in relation to any aspects that affect your retirement.





    COMMENTS

    To make a comment, please register or login
    dabi56
    17th Jun 2020
    11:52am
    And Jill loses half her money every 10 or 12 years when the share market crashes. We are living in a different paradigm now, after 2008 the market eventually went up because of Central Banks lowering interest rates to historical lows, this time if we get the V shaped recovery it will be because Central Banks are printing money.
    Franky
    17th Jun 2020
    12:27pm
    This imbalance in world economics has been going on for the best part of the last 40 years. I have listened to all the gloom and doom, but so far it's just been going on and on --- debt in the US now stands at over 26 trillion US$ and going up fast. Where will it end? Behind the scenes there are moves underway now to cut out the world reserve status of the US$ which will be disastrous for the US and possibly lead to a world wide reset of currencies and a new financial system. Meanwhile all that extra money printing is going into stocks and real estate.
    Anonymous
    18th Jun 2020
    11:36am
    You have to buy low and sell high to make real money in the market. Timing the market is more important than time in the market. I just laugh when advisors tell me time is the market is more important. If you buy a share at it's highs and it never gets back there you can't make money no matter how much time you have been in the market.
    Golden Oldie
    17th Jun 2020
    12:24pm
    Why do most financial advisers promote the slogan that it is time in the market, not timing the market, and make absolutely no attempt to sell off anything when the market takes a tumble, like in 2008 and 2020. It took 10 to 12 years to recover, who knows how long it will take for this one. The value of superannuation tumbled, distributions will drop, pension drawdown is based on capital value and by using the option to only half of the drawdown can be accessed for 2019 /20 and for the next financial year can be very detrimental to income to live on if you don't have other savings. At age 76 to 80, or above, time in the market is not very relevant.
    Youngagain
    17th Jun 2020
    8:49pm
    Golden Oldie, I suspect many retirees HOPE time in the market is not very relevant, because they are fearful of the future. The retirement funding system in this country is a disgrace, and causes major stress and anxiety for many who never anticipated investing in shares or dealing with risk and reward, and are now forced - at a time when age and reducing mental strength makes learning hard - to suddenly become investment gurus.
    Youngagain
    17th Jun 2020
    8:46pm
    It is a national disgrace and a deserved condemnation of Australian politicians (of both major parties) that retirees HAVE to understand risk and return and deal with share and managed fund investing. It makes ratings suggesting we have a good retirement funding system totally deceptive, because they take no account of the stress and mental anguish retirees face having to worry constantly about how long their savings will last and suffering penalty for having assets.

    In today's world, working class people who never dreamed of being share market investors, but kept their savings in the bank at a healthy interest rate and saw their parents retire comfortably with high interest on their savings, are now faced with suddenly having to become investment gurus just when their mental faculties are reducing. Many had little or no super but have healthy private savings, enjoyed a modest inheritance late in life, or downsized their home, so they are disqualified from a pension by a cruel assets test, yet they have limited capacity to earn income from their assets and struggle with stress and anxiety because their income is inadequate. It's disgusting that this situation exists in a comparatively wealthy country.

    Meanwhile, younger Australians are looking at articles like this and thinking 'No way can I save millions for retirement', so the temptation to reduce savings and qualify for a pension is strong. Yet very high salary earners are taking mega-millions in huge tax concessions, building massive war chests for retirement at taxpayer expense. 80% of the billions going in tax concessions on super go to people who will never need help to fund their retirement, while needy pensioners get far too little and those caught in the middle, with modest savings, get NOTHING and have to cash their assets and worry themselves sick about being poor in their final years, when their need for expensive care is likely to be greatest.

    The whole system is a mess and a disgrace. We can only hope the retirement income review will lead to reform, but I think most of us are aware that the likelihood is virtually nil.
    Mariner
    18th Jun 2020
    8:00am
    You said it absolutely the way it is, mate. Savers will be the losers in future as they are now unless you can save something the authorities do not know about. With computers checking everything you might be involved in that is going to have a fat chance.
    Hardworker
    10th Jul 2020
    12:52pm
    Youngagain - I too totally agree with you. Couldn't have put it better myself.


    You May Like