A common investing phrase that you might hear is don’t invest money that you can’t afford to lose.
This is the kind of phrase that sounds great on the face of things. It looks like a foolproof way to protect yourself. But is it actually good advice? Probably not. Let’s break it down:
No risk, no reward
The most important part of the phrase is the word “afford”. This has nothing to do with the amount of money you invest, but is actually about “impact”. What would be the impact on you, if your investment were to lose value?
Every investment you make has a risk of not giving you the returns you expect it to give you. The higher the returns you expect, the more risk you generally take to get those returns. Taking more risk gives you the chance at higher returns, while taking less risk reduces your opportunity to get higher returns.
The impact of a risk is much more important—in other words, what you might be willing to lose for the potential of an upside, and how long you can manage holding that loss. To figure out the answer to this question, you need to ask yourself what would happen if your investment decreased in value, today.
If all the money in your chequing account decreased in value, that would have a very significant impact on you. But if you had some money invested in a fund with the intention of keeping it there for 10 years (also known as a 10-year time horizon), the impact of a day-to-day fluctuation would be insignificant. You might not even notice!
By finding ways to reduce the impact of a risk, you may be able to accept a higher chance of a loss in the shorter term, for a higher return in the longer term.
A long time horizon
A long time horizon is one way to take more risk, while reducing the potential impact of that risk. This is especially true if you combine that long time horizon with diversification (more on that in a second).
Let’s say you have some money that you want to invest, and you don’t mind waiting 10 years for your returns. If it’s a reasonably volatile investment, it will gain and lose value quite a bit over the course of those 10 years—but anything that happens in the second, third, fourth or ninth year isn’t going to affect you.
Of course, there’s still the risk of the investment not giving you the returns you want over the 10 year period. But by investing for that longer time horizon, you don’t really need to care too much about the ups and downs along the way.
In other words, you can afford to have that investment lose value in the short and mid term, as long as it gains value in the long term and you still believe the underlying investment has the chance of achieving that growth. For example, holding an investment in a company that wants to continue to run video stores as its core business and innovation may not be ideal—but Netflix worked out okay!
Diversification is another way to increase the amount you can afford. Let’s say you have $100 to invest. If you put that entire $100 into one investment that has a high likelihood of losing some of its value, then the impact of that high risk is pretty high—in the absolute worst case, you could lose your entire $100.
If you split the $100 into two parcels, and put one in a risky investment and one in a less risky investment, then you would be cutting the potential impact in half. You’re more likely to lose $50 than to lose the entire $100 (although there’s always a chance that you lose the whole thing).
You can then split this as many times as you want—you can even invest in a fund to split it into 500 chunks, or more!
The point is, diversification helps to reduce the potential impact of any one investment choice losing value. The likelihood of it losing value doesn’t change, but the impact it has on you does.
So when you look at it this way, that phrase we started with is technically true. But only technically. Investing money that you don’t care about losing is one way to reduce the impact of the risks you’re taking, but it’s not the only way.
You can achieve the same goal, invest more, and get access to higher returns, by investing with a longer time horizon and making sure you’ve managed your risk through diversification.
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.