Investing in the share market can be risky business, and for the bulk of us mere mortals, financial jargon may as well be written in Hindi when trying to learn about it.
Unless you stay informed and read up about financial markets, products and services every day, you could be entering the world of investments blind. Many people as a result turn to investment experts and professionals, ultimately relying on expert and professional investment advice to help them feel less worried about their decisions.
What you need to remember though is that your investment decisions ultimately sit with you. Professionals can guide you, though they are not accountable for your money in a real world sense – it’s you who needs to understand risk and make strategic investment decisions to grow your money.
Investment risk – can you sleep at night?
There are some days, usually ones where I’ve invested money in a set of shares that could go up or down, that I wish there was no such thing as risk. The panic, the sweats, the over-dependence on prophesying signs of where the market is heading; none of them are pleasant emotions to feel.
Though as risk is a fact of life, the best thing you can do is attempt to manage your risk more effectively. You need to be able to sleep at night, feel good about the ‘long term’ prospects of your investments and try and not feel the above emotions on a daily basis.
Australian’s are risk adverse, putting lots of money in high interest cash accounts
There has been a trend reported that Australian households are taking their money out of the stock market and putting it into cash assets, such as term deposits. In fact, since 2008, Australians have taken around $68 billion out of the share market, with a commensurate bump in the amount of money heading into term deposits.
The returns on cash are favorable in tough market conditions (as any return is a good return in bad times) but when the markets are up, cash quickly looks to be boring and treading water with your money.
So given that we are risk adverse in Australia and we like being extra careful with our hard earned savings, is there a way to still make gains from our money? The answer isn’t simple. A professional will tell you to diversify, so as to have a multitude of investments (including cash) so as to hedge your bets.
Here are some thoughts on risk, investments and what it means for your money.
The components of investment risk
Contrary to what you may believe risk is not something that is easily definable. However, when discussing risk in relation to investments – there is generally a direct correlation between the risk you are willing to take and the potential return it will make.
I consider high risk to be a subjective topic that is a result of high probability and/or significant consequences. For example investing in a particular mining company might be considered high risk if the returns are dependent on the probability that their exploration is successful, and consequentially if they were not successful the share price might plummet.
Likewise purchasing a property off the plan – it is unseen and might be considered high risk as significant losses might ensue if the property turns out to be in poor condition or in a bad area. Big risk is linking high probability with significant negative consequences.
This is what we want to avoid.
Investment risk VS investment reward
High risk might be essential to great rewards, but it is not the key to great rewards. There are probably a million people in the world that have invested in the ‘next big thing’ that can testify to that. For myself, personally (and I should probably mention that my financial personality does not tend towards the high risk end of things), I would prefer to slowly and steadily save money rather than risk and make (or lose) a packet. It might make me less well-off in the long run, but it’s the approach that matches my financial personality. Consider your financial personality, do you like a gamble, can you cope with significant losses?
Risk is relative
Risk is not a clear-cut thing. For instance, you might think putting all your money in a term deposit is the safest thing to do with it, and in the short term, you might be right. But the chance of the term deposit keeping up with inflation is minimal. So while you might think stocks are risky, some experts suggest if you’ve varied your share portfolio enough and aim to keep it over a the long term (BT Financial Group, Bigger Picture Campaign, 2011), it might just help your money beat inflation (and some more).
Risk can’t be controlled to the nth degree. The best approach is to keep calm and maintain a steady course. Think beyond the short-term; your investments should not be about what’s happening in today’s stock market, but about long-term growth and diversification (assuming you have taken strong financial advice and purchased shares that are less speculative and part of a longer term strategy).
A knee-jerk reaction could lose you significant money. Understand your own financial personality and risk tolerance, and set up your investments from there.
Are you feeling uncomfortable with your exposure to risk?
I hate being uncomfortable. I hate being too cold or too hot. I especially hate when my socks get wet and I’m a couple of hours from being able to change them. But there are different kinds of uncomfortable. There’s the uncomfortable feeling of a first date or a big workout, but then there is the reward of meeting new people, feeling good about yourself and achieving a challenge.
Sometimes we need to be comfortable with feeling uncomfortable. I, as a non-expert investor, would still always want to stay within my risk profile (my overall risk tolerance level if you will).
There’s a difference between taking an abseiling course to challenge yourself and trying to climb Everest without any equipment. Knowledge, preparation, sensible rational decision-making, these are all stalwarts of good financial practice. But perhaps I need to look at being a little less comfortable, putting myself out there a bit more to reap potential financial rewards.
Though as mentioned previously, I am not that tolerant of risk so it would definitely impact my ‘can I sleep at night?’ methodology.
The fear of failure drives our risk profile
Fear is a protective tool. It stops us from getting too close to the edge of a cliff or driving too fast down a highway. But allowing ourselves to completely give in to fear can have some damaging effects on our finances. This isn’t just about investment; it’s about our whole financial wellbeing.
Fear can stop us from finding better employment, getting a higher level of education, investing in property or even taking a pay cut to increase our quality of life. It’s important to know whether fear is the force getting in the way of us making ultimately smarter and more strategic decisions.
Fear and risk together
Understanding risk allows us to make sensible decisions, and take some chances, in order to make financial gains. Too much fear (or too little) is the lack of understanding of risk, we make financial decisions at extreme ends of the spectrum, investing nothing or everything.
The key is to use fear to research properly.
Understand the risks of investment and their relationship to potential gain. Invest within your risk profile and always consult professionals before making big financial decisions for a ‘second opinion’ of sorts.
So how do you invest your cash?
Now that you’ve considered your feelings towards risk, how do you set about investing your savings to reap a decent return? People who do successfully grow their wealth by investing swear by it and encourage people who don’t currently invest to do the same. “It would be silly not to”, although after the crash of the stock market, they’re probably singing a different tune.
There will be no investment advice given in this article and instead we have simply listed some of the more popular investments out there that people use.
Fixed term deposits
If you like certainty and knowing exactly how much interest you’re going to earn in a fixed amount of time, fixed term deposits are for you. You’ll only be making slightly more than if your money sat in a regular high interest savings account (normally) but it’s a good start.
The downside of term deposits is that they’re inflexible, and will cost you money should you need to access money before your time is up. Without careful supervision, once your deposit matures it can be instantly rolled into a low-interest account. And, of course, it is an investment option that cannot keep pace with inflation in many cases. None of this is a deal-breaker; it just means that term deposits probably shouldn’t be your sole investment according to many investment professional who look to make a diversified portfolio of investments.
In times of economic uncertainty, people often flock to gold. This means that when times are good (and share markets are up) – gold is often considered ‘cheap’. When times are bad, gold prices go up as demand for it increases due to market uncertainties.
A good rule of thumb is that if someone tells you to invest in gold, it is often too late. Much the same as if a taxi driver gives you a hot share market tip – run for the hills.
Apart from buying gold from the jewelers (which comes at a higher as it includes labour), you can invest in gold in a number of ways. Through shares that are gold focused or directly via the likes of Perth Mint (they sell actual bars, coins and more).
The share market
The share market allows you to buy parcels of shares in other companies. I like to look at it as I am actually buying a little bitty chunk of a company.
This means I can own a bit of a bank, retailer or some other business that I have faith in for future returns.
Owning a little bit of the company via shares gives me a few potential benefits. I share in their wins (with dividends in some cases or share price growth), I share in their losses (sadly if they do badly, so does my money) and all the while my initial investment has the ability to grow over time.
To summarise; it’s all about diversifying your investments to hedge risk
Just because you’re looking at low-risk investments doesn’t mean you can only invest in high interest savings accounts and term deposits. Balancing your portfolio across a couple of options can still remain very low risk, without necessarily having to lose out to inflation. Talk to your financial advisor about your investment options and develop a plan that works for you.
As someone about to take another plunge into investing, I find all the information that floats around often more confusing than helpful. So what am I to do? Stay defensive in the expectation that the market may plunge further? Or take a chance it might rise from here, and start investing? It’s a pretty scary prospect.
Ultimately the essential tactic is to use this fear to prepare myself properly, and not allow it to scare me into inaction.
This is why understanding risk is vital if you wish to be a good investor. Manage your risk, manage your money and always ensure you can sleep at night.