The dangers of not understanding investment risks

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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 could 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. The people who invested their life savings in companies such as Westpoint and Estate Mortgage are proof of that, 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 if the 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 timeframe 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 decide they will need an income of $40,000 a year in today’s dollars. Jack is an inexperienced and very cautious investor, and is so risk averse that even on optimistic forecasts his superannuation will earn six 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 nine per cent per annum.

If inflation averages three per cent per annum, Jack will need to accumulate $1.49 million at age 65. This will require monthly contributions of $2147 to superannuation, which is probably well above his capabilities. Because Jill’s investment strategy will provide a higher return, she needs to accumulate only $1.114 million, and has to invest just $994 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.

Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance. His advice is general in nature and readers should seek their own professional advice before making any financial decisions.

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Written by Noel Whittaker

12 Comments

Total Comments: 12
  1. 0
    0

    Should read the Fine Print, almost need a magnifying glass to read.
    Past performances are no guarantee for future performances.
    Low risk, high risk and no risk (under the mattress) It is what you are willing to lose, if all or part fails to perform.
    The adviser has his money/payment ongoing even when under performing.
    Risk is against what you are prepared to lose as well to gain.
    Heard the saying Sh** happens.

  2. 0
    0

    “$1000 in the bank today should still be $1000 tomorrow”. Well….yes. Unless of course the bank goes belly up. They do from time to time. Or unless the government/APRA freeze your money to stop a bank run. This is not make believe because the practice of fractional lending, where banks lend money which never existed in the real system, means that when depositors come to withdraw their money en masse the banks have no option other than close the doors. Happened in Greece and Cyprus. May also happen here given the right trigger.

    • 0
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      Wrong $1000 in the bank today will not buy the same tomorrow as it today so you have lost purchasing power of your money. You need to grow your money so that it’s purchasing power remains the same or your money pile devalues.

  3. 0
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    “There is no SUCH thing as a SURE thing”. Remember that and you will stay wary.

    • 0
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      Hi Fast Eddie this is an explanation of a comment I posted yesterday that you responded to.
      I posted it late on the other website so you may not have seen it.
      ” I was not criticizing anyone who writes here especially not you. I get tempted to respond to issues regularly. I have been particularly upset by the way seniors have been spoken about and treated over the past three years but I feel raising this is like baying at the moon. Those who should be listening are often complicit in the denigration and further impoverishment of retirees. This includes others who profess to be seniors such as, dare I say it, the person who writes as Bonny. The notion that people like the Monitors of this website (Kaye Fallick) would propose to inflict a reverse mortgage on really old people so that banks can evict them in the months before they die has left me stunned. A special kind of selfish, mindless callousness often permeates the whole discussion. Undoubtedly the website owners got a fee for the promotion of the reverse mortgages. However most of the articles presented are benign and simply the news of the day as it affects seniors up for discussion.”

    • 0
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      Oh yes three is such a thing as a sure thing. Death and taxes.

      Just to set the record straight I am not a fan of and never have promoted reverse mortgages. I have only suggested the idea of paying back ones pension from their estate.

    • 0
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      Alex, please see my comments under your in yeaterday’s newsletter.

      Bonny, “pay back one’s pension from their estate” – what an utterly ridiculous think to say! You are not fooling anyone with your phony financial altruistic comments towards the Treasury Department, so hop off your high horse with your foolish pecuniary pretences. People are laughing at you. Get real.

  4. 0
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    Fast Eddie……your comment was NO better than Bonnie’s nor Alex’s so YOU had better get off your high horse and stop bullying others!
    Everybody has made worthwhile comments and it would be nice if you treated others with more respect.

  5. 0
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    A debt of gratitude is in order for giving such an awesome article, it was brilliant and exceptionally informative.WOW! Extremely intriguing. Much thanks to you for this web journal

  6. 0
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