When you’re investing for your future goals, it’s important to find the right investment strategies for you.  The amount of risk that you’re prepared to accept within your investment strategies can have a major outcome on your success in achieving your goals. Risk and return is an important concept to understand when it comes to investing.

When deciding which investments are right for you, it is important to understand the trade-off between risk and return and how to manage investment risk.

Understanding risk and return

One of the fundamental concepts of investing is the idea of being rewarded for taking on a higher level of risk.

Generally speaking, investments that have the potential to provide high returns over the long term will fluctuate more in value over the short term.  Some months (or years) they’re up, sometimes they’re down, but over the long term, on average, they produce strong returns.

You’re rewarded by accepting a higher degree of uncertainty in your returns over the short term by the likelihood of a stronger return over the long term.

At the other end of the spectrum, a nice safe investment that never declines in value (like a bank account) is unlikely to produce high returns over the long term.  Because you accept the certainty in returns, you forgo the opportunity to obtain higher returns.

The old phrase is true – the higher the risk the higher the potential return.

Generally, investments like shares and property have the potential to produce the highest returns over the long term but are also most likely to fluctuate in value over the short term.  On average, shares could produce a negative return once every 5-6 years.

Different types of risk

Investors face many different kinds of risk. One of the most common is the variability of returns. If returns don’t meet expectations, investors may not be able to meet their goals or afford their ideal lifestyle. Investments like shares have a high variability of returns over the short term (one or two years), but a lower variability of returns over the longer term (more than five years).

If you invested in a share today with the intention of withdrawing your money in a year, that’s taking on a very big risk. Because whilst you could be lucky and that share could make a 30% return, you also have a high probability that it’ll make a -30% return. Imagine that. If you’d invested $1,000 at the start of the year, how would you feel if, when you needed it in a year, you only had $700?

The average annualised return of the S&P500 (a measure of the top 500 US stocks) over the period 1973 – 2016 was 11.69% (source). But there wasn’t one year in that thirty year period where the market returned 11.69%. The average is just the average.

If you invested at the start of 1989, you would have made 31.5% over that calendar year. But the next year you would have lost 3.1%.

How about investing at the start of 2008 and making (losing) -37%? How would that make you feel?

The variability and timing of your returns can make a big difference. Which is why investments such as shares and property should be considered long-term investments – you have plenty of time to recover from the bad years and experience a number of good years.

All investments carry some risk due to factors such as inflation, taxation, an economic downturn or a drop in a particular market. Even if you choose an investment traditionally considered ‘safe’, such as cash, there is still a risk of inflation eroding the value of your capital or falling interest rates reducing the level of your return.

In my experience, people usually equate risk with the loss of capital.  In reality, one of the greatest risks you face is not having enough money to fund your future lifestyle expenses.  There may be no option but to accept a moderate level of risk (fluctuation in returns) in order to gain the potential for stronger returns over the long term that enable you to achieve your long-term goals.

How to manage risk

One of the best ways to manage risk is through the concept of diversification – not having all your eggs in the one basket.

The principle here is to spread your investments across different asset classes (shares, property, bonds, cash etc) with an understanding that each class will perform well at different times. So one year you may find that shares have a great year, the next year they’re down but your bonds are up.

The different weightings towards each asset class depend on many things – how much risk you’re prepared to take, how comfortable you are with the variations in returns, how much money you need to achieve your goals etc.

Summary

Every investment has its own level of expected risk and return.  It’s important to understand that you if you accept some short-term fluctuations in capital (i.e. a higher level of risk) you should be rewarded with a higher return.

During market downturns, it is tempting to sell your long-term investments and invest them into investments that are only suitable for the short term like cash and fixed interest.  This is the opposite of ‘buy low, sell high’ and probably the wrong thing to do in most cases. Over the long term, markets will revert back to averages.  If you have long-term money, it should remain invested in assets that will perform best over the long term.