Risk shouldn’t be a four letter word when it comes to investing your money – because a healthy risk mindset is just what we need to achieve high rewards.
Let’s say that back in November 2011 you had $100,000 to invest for 10 years. How would you feel today if you had earned a 10 per cent [1] annual return? That’s an extra $170,000 or so in your account.
Most investors would love to have achieved that type of return. It’s certainly a lot better than if you had placed your money in the bank – in this case, over the same 10 years, you would have earned around 2 per cent [2] a year – with the extra in your account only around $22,000.
But of course, there is a trade-off. Known as the risk/return trade-off, over the long term, you need to brave more risk to achieve more return.
Which is why, to be a successful investor, while you may never feel one hundred per cent comfortable with risk, it’s important to understand the risks you’re taking and to find ways to navigate some discomfort.
What is risk?
It’s primarily about two interrelated things.
It’s firstly about the bumpiness of the path you take when you invest. For example, while cash gives you a smooth ride, shares are often a rollercoaster.
In a single bad year, shares could lose 40 per cent or 50 per cent of their value – meaning that a $100,000 investment could drop in value to as low as $50,000 or $60,000. Ouch.
It’s secondly about the risk that you won’t reach your destination. That is, at the end of the time over which you planned to invest, you won’t have the amount of money you expected.
These are linked because if you select a higher risk investment – which is likely to give you a bumpier ride – then there’s a chance that you will bail out of your investments when market values drop and put all your money in cash. Which is one of the worst things to do – because while the dip is likely to be temporary, selling locks in losses, from which it could be difficult to recover. Even if you sit on the sidelines just for a few months, research shows that investors have typically lost about 2 per cent in annual returns by jumping in and out.
Of course, you could choose lower risk investments. This may feel like playing it safe. However, this introduces a different risk – where the purchasing power of your money is eroded by inflation. Many cash savings accounts are currently paying interest of less than 0.5 per cent. Meanwhile, inflation (measured by the Consumer Price Index) rose about 2 per cent in the past year.
So, while being a conservative investor may feel safe, it’s not. Having a low risk mindset may mean you miss out on valuable returns and your money could lose real value.
So, what can you do?
1. Reframe your view of risk
First, reframe your view of risk. If you’re investing for the long term, what the sharemarket does on a daily, monthly or even yearly basis is of trivial importance.
If you plan to invest for at least 10 years, then what do you care about the market’s bad behaviour over 10 days, 10 weeks or 10 months? It’s irrelevant.
If you can capture high long-term returns, what does it matter if along the way you lost and gained?
If we view it logically – head not heart – we should only worry about our destination.
Now creating a risk mindset like that can be easier said than done. While we may want to invest with our head, most of us have a good dose of heart – and can’t withstand the dramatic losses that can come with an all-shares portfolio.
2. Diversify your assets
So, the second thing you can do is identify a mix of assets – including Australian shares, international shares, listed property, bonds and cash – that gives you your ideal version of risk and return.
Alternative investment avenues you might not have thought of
The mix you choose will depend on how comfortable you are with risk. When investments drop in value on your investment journey, you need to be able to stay invested so that you have the best chance of reaching your ideal destination.
If you want to earn higher returns and can handle dips of 40-50 per cent every three to four years (over 10 years), then you could consider a ‘growth’ type asset mix with say 75-80 per cent in shares and 20-25 per cent in bonds and cash.
A more balanced approach – with a 20-25 per cent dip two or three times in 10 years – might mean a ‘balanced’ asset mix with 50-60 per cent in shares and 40-50 per cent in bonds and cash.
Or if you know you need more stability to sleep at night (a dip in value one or two times in 10 years), and are happy to accept more moderate returns, then you could consider an asset mix that is 20-30 per cent in shares and 70-80 per cent in bonds and cash.
What matters most is that you feel comfortable that your chosen mix of risk and return is right for you – and that you can stick with it when markets take a dive. And of course, if you need help, then it’s a great idea to seek professional financial advice to help improve your risk mindset.
[1] S&P/ASX 200 TR Index AUD, 10 years to 31 October 2021, compounding monthly
[2] Bloomberg AusBond Bank Bill Index AUD to 31 October 2021, compounding monthly
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