What is risk anyway?
Different investments have different levels of risk. But what does this mean in practice? Should you focus on low-risk investments, high-risk investments, or both? What is risk anyway?
Let’s get to the bottom of these questions and sort out what risk is, what to look out for, and how to manage it.
What is risk?
We usually think of risk as the odds of losing something, but in investing, it’s a bit wider than that. Risk is the chance that you won’t get the returns you hoped you would get.
Here are a couple of extreme examples: if you bought a safe and put your money in it, you would be taking very little risk. You would expect your returns to be exactly 0%, because your money’s just sitting there. But you could also rely on those returns being 0%.
On the other hand, imagine buying a lotto ticket. When you buy a lotto ticket, you’re hoping to win millions of dollars. But we don’t need to tell you that the odds of that happening are very small. Walking away with nothing is a lot more likely than winning big. So that means a lotto ticket is very high risk.
In the investment world, a low-risk investment is generally something that generates stable, relatively dependable returns, with a relatively low likelihood of losing some or all of your initial investment. Putting money in the bank is an example of a low-risk investment: the bank pays you a fairly low interest rate, but in exchange for that, it offers relative safety. The odds of your bank going bust and defaulting are very low.
A high-risk investment differs as it’s generally less stable. It may give higher returns, but it also may not deliver those returns—in fact, you may be more likely to lose some or all of the money you started with.
The other side of risk
But there’s another side of this equation: the returns. Investments with more risk tend to get higher returns. If you want higher returns, you need to be willing to accept less certainty.
You can see this when you look at the returns of different investments. Over the past year on Sharesies, the lower-risk Smartshares NZ Bond fund has given an average return of a bit over 3%—that’s including dividends. Compare that to the higher risk Smartshares US 500 fund, which has returned a whopping 24% over the last year.
The difference is that bonds tend to be stable in price, and pay investors regular coupon payments (like an interest payment). So you can be more certain about the lower return when you buy in to the NZ Bond fund. In exchange for that certainty, you give up a shot at the higher returns from the US 500 fund. That 24% gain was much less likely than the NZ Bond’s 3% gain—it could have been 10%, 5%, 2% or even gone backwards.
Opportunity comes with risk—if you completely avoid riskier investments, you’re potentially giving up the better returns that higher risks may bring over time. This isn’t a bad thing! If you don’t like to take risks, you don’t have to.
But it’s also not an all-or-nothing proposition. There are some strategies that let you take on some risk, without taking huge risks. Here are a couple of ways to do that:
Diversify, diversify, diversify
Diversification helps you manage your risk by putting your eggs in lots of different baskets. For example, if you bought shares in the Smartshares US 500 fund on Sharesies, you’d get a little piece of 500 different companies in the US. That means that if one of those companies doesn’t do as well, you possibly have 499 other companies picking up its slack. Diversification gives access to the returns from lots of companies, without taking the bigger risk on just one of them.
Of course, this approach only protects you from the risk of one company performing worse than the market in general. You still have the risk of returns from the entire market standing still or going backwards—which is what can happen in a recession or a big shock like the GFC (Global Financial Crisis) or COVID.
Some investors will split their money between higher-risk and lower-risk investments—for example, by investing in both the US 500 and NZ Bond. That gives you access to some of the higher potential of the US 500, while also keeping some of your money in lower-risk funds to balance things out. Or, you can invest in a bunch of companies, while also investing in managed funds and exchange-traded funds (ETFs). This gives you the potential focussed upside of the companies, while also giving you the broad diversity of the managed funds and ETFs.
This approach makes everything a bit smoother. You don’t have as much access to big returns as you would if you invested all in one thing, but you’re also much less likely to lose everything. Not a bad deal.
Take your time
Time horizons are another way to manage risk. A well-diversified, higher-risk investment like the Smartshares US 500 fund or the Smartshares NZ Top 50 fund tends to go up and down in the short term. This isn’t actually a big deal if you have a long time horizon, because a dip in the short-term won’t affect you. But you can only do this if you don’t need (or want) that money today or any time soon.
So when you’re thinking about risk, you can manage it by asking yourself when you want to get your money back. If you want it tomorrow, you’re probably better off putting it in a chequing account. If you can wait for a few months or longer, you could consider a lower risk strategy (such as bonds). If you can wait for a few years or longer, you might decide to consider a higher-risk strategy.
As always, it’s your choice
Risk comes down to your goals and what you’re comfortable with. Taking lots of risks can give you access to higher returns, but with larger odds of losing your investment—especially in the short term. Taking very little risk means you are less likely to lose your investment, but you’re also less likely to get higher returns down the track.
You might end up somewhere in the middle. Exactly how much risk you take, and how you manage it, is ultimately up to you. But just remember that it’s not an all-or-nothing deal. You can “have it all” by taking some risk and managing it by diversifying and staying in for the long haul. We think that’s pretty cool.
Ok, now for the legal bit
Investing involves risk. You aren’t guaranteed to make money, and you might lose the money you start with. We don’t provide personalised advice or recommendations. Any information we provide is general only and current at the time written. You should consider seeking independent legal, financial, taxation or other advice when considering whether an investment is appropriate for your objectives, financial situation or needs.