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What is Investment Risk?

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When it comes to our money and finances, we often get asked how much risk we want to take, and what “level of risk” we are comfortable with. This is a really difficult question to answer as risk means different things to different people, and what does risk really mean when it comes to our money?

 

Does risk mean losing money?

No, not necessarily. With investments (or any asset really, even our homes), values can go up and down. When the value of our house goes down, do we automatically worry as we have “lost” money? Generally, no. We only “lose” money if we need to sell the house at that point in time, when the value has fallen.

Taking risk means that we are more likely to see values going up and down. We only lose money if we have to sell (or sometimes choose to sell) when the value has fallen.

 

What is volatility?

Values going up and down over time is called “volatility” and this is linked to risk. The more risk we are taking, the more “volatile” the value of that asset will be, or the bigger swings in value we will see over time.

This is why time is important…

 

Why time is important when it comes to risk

If we know we need to spend the money, or sell the asset within the next couple of years, we won’t want to experience big swings in value, as there’s a chance we may need to sell at the bottom, and won’t have time to wait until the value recovers.

If we don’t need the money for many years, then we have the ability to ride the bigger waves and wait for values to recover.

The less time we have until we need the money, the less risk we should be taking with it. The more time we have, then the more risk we have the ability to tolerate.

 

When it comes to investments and KiwiSaver, what does risk actually mean?

In an investment portfolio or a KiwiSaver, we generally hold some sort of a combination of shares (also called equities) and bonds (also called fixed interest).

Shares (equities)

This is where we own a share in a company or many companies. When those companies do well, the value of our shares go up. When those companies do badly, then the value of our shares go down. If a company does very badly, it could go bust and then the value of our share could be worth nothing at all.

We invest in shares, because over time, the value of shares is most likely to give us long term growth and protect us against inflation as the companies grow bigger and bigger. It is shares though, that give us most of the risk in our investments.

If we hold lots of shares in different companies all over the world, then one company going bust won’t make much difference at all to our investment. If we only own 3 shares and one of them goes bust, then it would make a much bigger difference!

Financial risk is reduced by “diversification”, spreading the risk as much as possible. Diversification means investing in lots of companies doing lots of different things, run by lots of different people with different views of how to do things, in lots of different countries around the world.

The more shares we have in our investment or KiwiSaver, the more risk we are generally taking.

 

Bonds (fixed interest)

The easiest way to think of a bond is that it is a bit like a term deposit, but from a company rather than a bank.

As a “bondholder”, we lend money to a company for a certain period of time, and in return we get a fixed rate of interest paid to us from that Company. At the end of the time period, we get paid our original loan amount back.

The main risk with a bond is that the company can’t pay us back at the end of the term, so with bonds, we can reduce our risk by:

  • Only lending money to companies that we think will be in a position to pay us back,
  • Diversify by lending money (holding bonds) to lots of different companies operating in lots of different industries, all around the world.

Bonds in portfolios are not generally considered to be that risky if they’re well diversified and the investment manager is only lending to good companies.

The more bonds we have in our investment or KiwiSaver, the less risk we are generally taking.

 

In conclusion….

How much risk we take with our investment should firstly be based on how long it’s going to be until we need to spend the money (or sell the asset), and then based on how much volatility we are prepared for. Can we emotionally tolerate the big swings?

The more risk we take, the greater the possible return, but the bumpier the ride!

That’s why I’m here; to keep you on track during the bumps so that you have a better chance of reaching your long term goals.

 

This article should not be considered to be personalised financial advice. Please seek advice before making any changes to your own finances. A Disclosure Statement is available free of charge and on request. s