The markets have been shaky recently, which adds to many people’s fear of taking on investment risk. But there are ways to find balance.
In most investment structures, risk and return are intertwined. The higher the risk, the better the return.
“When confronted with the sharemarket moving up and down, there’s a perception that it’s just too risky,” Julia Lee from Burman Invest says. “There’s a reason behind this: the prospect of losing is about twice as powerful as the pleasure of gaining.”
In general, people are more willing to take risks to avoid a loss, than to make a gain. In other words, we feel the loss of money when a share price goes down far more than when that same share price goes up. Actually, the share price would need to rise twice as far in order for us to feel compensated a loss. This leads to a negativity bias which can cause an investor to miss out on bull markets and panic when markets go south – with massive long-term consequences.
“Understanding this very human quality of loss aversion could be the key to becoming comfortable with risk,” Lee says.
You can see her full discussion on getting comfortable with risk here.
Investment risk versus return balance
While it’s natural for some to be risk averse, holding back from all risk in investing means you’ll miss out on good returns. Instead, there are ways to balance out your natural caution and get ahead.
1. Know the market
A lack of knowledge can lead to an investor thinking something is higher risk than it actually is.
Warren Buffett is famous for only investing in what he knows: “Investment must be rational; if you can’t understand it, don’t do it,” he cautioned.
That goes for understanding the companies, indexes, properties or commodities you plan to invest in; as well as the market itself.
There are two levels of influence affecting the movement of share prices.
The first is the overall economic climate. Share prices are affected by the level of interest rates, currency fluctuations, health of the economy and the general level of confidence.
Ask questions, research widely, compare historical data, follow the financial pages, listen to podcasts and YouTube channels and read the news daily.
2. Calculate your risks
So, the bare minimum risk you need to be comfortable taking on should bring you a return that grows your money, not babysits it and charges you for the privilege.
The same goes for taking on too much risk: that old adage “if something sounds too good to be true, etc” is never truer than when investing. Be honest with yourself about the true risk of your investments. Many are not worth pursuing unless you’re using money you can afford to lose outright.
3. Watch your cashflow
Reducing investment risk means staying in control of when you buy and sell. To do that, you need to ensure you have adequate emergency funds (equal to six months or more of living expenses) to call on in the event of financial stress. You don’t want to be forced to sell shares when the market is up just so you can pay your mechanic.
Given the low interest environment we are currently in, it’s hard to know where to keep your emergency stash and still remain liquid (see ‘inflation’ mentioned above). The best options are:
- offset account – your emergency savings will effectively reduce your mortgage, so the return is pretty good.
- high-yield savings account – if your loan doesn’t offer an offset account (many fixed-loans don’t have this option), find the best savings rates via a comparison site like Canstar, Finder or Mozo. Or call your bank and ask for a better savings account.
4. Diversify your investments
A good way to manage investment risk is to spread your investments across different asset classes. Diversification reduces overall risk because it leaves you less exposed to a single economic event or single asset fluctuation. When one asset performs badly, another may do well.
Consider investing across a wide variety of assets like:
- property – commercial and residential
- shares – across industries
- managed funds
There are other alternatives, but note that these are considered higher-risk investment options:
As well as diversifying across assets, you should also diversify within asset classes. For example, if you are holding shares, ensure they are across different sectors like banking, healthcare, technology and industry. You can also diversity by buying both Australian and international shares.
5. Employ dollar cost averaging
For everyday investors, trying to pick a share’s peaks and troughs can feel like a game of pin the tail on the donkey.
Dollar cost averaging is one investment strategy that involves investing the same amount of money at regular intervals, regardless of the price of the investment at the time. It can significantly reduce reduce the timing risks associated with the sharemarket as it reduces the impact of market movements on the value of your investment.
6. Commit long term
Unless you’ve turned into a day trader, chances are you’ll really only benefit from the sharemarket by being in it for the long term. That way you can harness the power of compounding by reinvesting any returns, as well as cushion yourself against smaller market corrections.
While it’s impossible to predict the market ups and downs, it’s long been proven that missing just a few days of positive market gains can significantly reduce the value of your investments.
Fidelity International created a tool that illustrates the potential differences in returns from missing the 10 best market days in the Australian and various overseas share markets. You can find it here.
The cost of missing just 10 good days between the years 2003 and 2017 on a notional $10,000 investment? That was $12,838 – or the difference between taking home $34,206 versus $21,369. Which is close to a 40 per cent loss.
7. Set your risk threshold
Determine the extent of risk you are willing to take on upfront. This will vary over the course of your life – a young investor without family responsibilities will have a different appetite for risk than someone older with dependents (and all the costs associated). Assessing your risk threshold and rules will therefore be an ongoing exercise and one you should carry out at least annually.
There are some specific trading orders that help you better manage investment risk. They are similar to setting a reserve price at a property auction – the house won’t sell for less than you are prepared to take.
They allow you to set a specific rate at which your position will close, in order to protect your profit or minimise your loss.
A stop-loss order helps reduce your investment risk by protecting you from sudden market pullbacks. It means you automatically sell your shares when they retreat below a certain price.
You can set a take-profit order when your shares hit a certain profit level. While you do risk missing out on any further gains, you effectively protect yourself at a profit level you are happy with.
8. Know the difference between gambling and investing
“Individual stocks are one of thousands of options. Trying to ‘pick a winner’ is like betting your hard-earned savings in a casino,” says Align Financial‘s founder Darren Johns. “While you can win big on a single bet, the odds are against you when it comes to picking the right stock and also at the right time.
Empirical data tells us that you’re better off betting with the whole market, rather than on individual companies. Through a low-cost, highly-diversified portfolio, investors can grow their investments by letting time and compounding interest do the work.
Even full-time, long-term investors find it difficult to ‘pick winners’. Why would you be better at it than them?