Risk and reward often go hand in hand, the bigger the risk, the bigger the return. Each individual will have a different risk profile, and I am hoping to help you understand your own in this post. One of the most important parts about investing is doing it in line with your risk profile, so you can comfortably sleep at night. If you have a low risk tolerance and you are investing in highly volatile, risky stocks, you probably won’t be able to hold on for the tumultuous ride and will sell too early or at a loss. On the other hand, if you have a high risk profile and you invest in low-risk investments, you probably won’t feel like your returns are high enough and will want something more. Read below to find out what your risk appetite is and what investments may suit you.
Low Risk Appetite
There are a few things you can do if you have a low risk appetite. One, is obviously keeping your money in cash. There is no chance of losing any money by keeping it in cash and there is the ability to build interest on your savings also. This is considered the safest investment as there is no risk. Keep in mind that while you may not lose money physically, the value of your savings may actually go backwards thanks to inflation.
Inflation is a rise in the price level of goods and services over time, which means over time you can buy less for each dollar. This essentially causes your money to lose value as it can buy less over time. Inflation is generally a percentage, and governments ideally like it to sit between 2-3%. Therefore, if your savings are sitting in a bank account earning less than this you would actually be losing money. For example, if your savings account was gaining 1% interest but inflation is at 2%, you would actually be losing 1% a year. For the short term this is worth paying for your money to stay safe, however for the long term, it is not a good wealth building strategy and is probably more risky than investing in other assets.
Another low risk option would be investing in bonds. A bond represents a loan made to a borrower (either the government or a company) and that loan then needs to be paid back over time with interest. It is similar to how we borrow from a bank for a home loan, the investor (you) is the bank and the government/company will be paying back both the principle and interest over a set time period. Bonds are normally considered relatively safe investments but do carry some risk, as the borrower may fail to pay in some unlikely instances. Therefore, bonds aren’t as safe as cash in the bank but are definitely considered safer than property or shares.
Medium Risk Appetite
I’d classify a medium risk appetite as wanting a increased return while still having a safety net. This is best achieved by having a percentage of your money invested in some high risk options, and the another percentage invested in low risk options. So having a portion of your portfolio in cash and bonds, and some in shares or property. Having the lower risk options would steady out some of the volatility you may see in the higher risk options.
High Risk Appetite
A high risk appetite would see you investing mainly in growth assets such as shares and property. These types of investments tend to carry more risk but also give you the highest returns. Within these two investment options there are definitely more riskier and less risky options to choose from. For example, an ETF would be a much safer option than investing in cryptocurrency. Crypto is much more volatile than ETFs, meaning there are bigger, and there are many more market fluctuations in cryptocurrency. When looking to invest in highly volatile shares, or even just shares in general, I’d be asking if you were down 10%, could you still sleep at night? What about 20%, or even 30%. These are the numbers crypto are seeing in very short time frames. You may see these in other shares too, but with a long term buy and hold strategy, these short term market fluctuations aren’t really important. I will explain why in the next section.
How Do Time Horizons Alter Your Risk Profile?
Time Horizons are important when it comes to investing. Depending on how much time you have will ultimately change your investing strategy. If you only have a short time horizon, say 0-5 years, you would ideally play it very safe and keep your money in cash. If you need to deploy this money in the next few years there is a higher chance of there being a market dip so you could be withdrawing it at a loss.
There is a really great way of simplifying what the different types of risk mean for portfolios. All shares will have highs and lows (volatility), and it is all about riding these out. If you have a short time period, a lower risk portfolio would be comprised of cash, bonds and some shares. While the shares would provide good returns, the bonds and cash would decrease the volatility and decrease the number of down turns. For example, in a 10 year period you might only have one down year.
In a balanced portfolio, you may still have some bonds and cash, but would have a larger portion of shares. Again, the shares would provide good returns but you would still have some stability thanks to your low risk investments. If you were investing over a 20 year period, you may only have four down years.
In a high risk portfolio you would have a majority if not almost all shares. This would give you the best returns but would also come with much higher volatility as you don’t have those bonds or shares riding out the downturns. So in a 20 year period you may have about six years out of twenty being down years, but in the long term you would have much better returns.
So how does this effect time horizons? If you were investing in a high risk portfolio for only 5 years, there is a 30% chance that at the end of that time you may be withdrawing in a downturn. While you would still have a 30% chance over 20 years, you have had many more years for your money to compound and grow that even if it did drop you would still be well above your initial investment. It works the same way though, if you were investing for twenty years with a very low risk portfolio, you may only be making about 3-5% per year instead of 7-10%. Yes there would only be a chance of one or two years where you would have a downturn but you wouldn’t have the same returns to outrun that drop. If you invested $50,000 at the start of a 20 year period, and one option was for 3% and one was for 8%. Your final sum would be largely different. Even though the 8% portfolio would be more likely to have downturns, in the long run you would still be way ahead.
As you can see by the graphs above, a difference of just 5% over 20 years equates to approximately 155K, three times your initial investment! So while the 8% portfolio may have more downturns than the 3% portfolio, if you can hold on for the long term you will be much further ahead than if you had played it safe.
If investing for the short term (5-10 years) a good mixed portfolio is most ideal. If investing for the long term (10+ years), high risk is potentially your best option. This may change depending on your risk appetite, and if you are conservative you may want to take a more balanced approach for long term investing, and not invest at all if only looking at a 5-10 year time horizon. At the end of the day every person is different, and we all have our different comfort levels and it is best within those to an extent.