What is risk anyway?

If you log into Sharesies and poke around, you’ll see that 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?

We thought we’d get to the bottom of these questions and sort out what risk is, what to look for, and how to manage it.

The basics: 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.

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 NZ Bond fund has given an average return of a bit over 3%—that’s including dividends. Compare that to the higher risk 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 regular dividends. 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—and if you completely avoid risk, you are potentially giving up the better returns that higher risks can bring.

It’s about understanding risk

You can see from these examples that nothing is really risk-free. By investing in something relatively low-risk, you’re essentially giving up the higher returns of a riskier investment—this is a risk in and of itself.

The trick is to understand your risks rather than avoid them entirely. We do this all the time in our regular lives—putting on a seatbelt is understanding the risk of a car crash. Never leaving your house is avoiding it entirely. It’s pretty clear which one you prefer!

It’s the same thing in investing. You can avoid risks entirely if you want to, but the cost of doing so is pretty high. Every dollar you invest in something low risk is a dollar you’re not investing in something higher-risk. But you still want to manage those risks by doing the financial equivalent of wearing a seatbelt. Here’s how you can 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 US 500 fund on Sharesies, you’d get a little piece of 500 different companies in the United States. 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.

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 the other way to manage risk. A well-diversified, higher risk investment like the US 500 or the NZ Top 50 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 tomorrow.

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 years, something higher-risk may be the strategy for you.

As usual: it’s up to you

As with most of our investing advice, 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’ll probably 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.