Often people will argue that the stock market is too risky to invest in. Especially for those of us that grew up in the shadow of the GFC – putting your money at risk seems too much. Far easier to protect your hard-earned when it is safely insured in the bank.
The problem with that attitude is that you’re missing the bigger picture. Over the long term the stock market has been a fantastic wealth creator. By missing out on this opportunity, we are setting ourselves back later in life. Forcing ourselves to delay retiring and to keep working. Forcing ourselves to take a job for the paycheck. Most of all, forcing ourselves to work for our money rather than have our money work for us.
When it comes to investing your money, have the following thoughts ever come to your mind: “I want high returns, but at low risk” or “I want to get 30% annualised returns, but must keep my principal safe”. If so, then you are setting yourself up for disappointment. And don’t blame the financial markets or your luck or your investment advisor.
Rather, take some time to understand that earning a high return at low risk is incompatible. If you want to create wealth for yourself and your family, you need to take some calculated risks and can’t be totally risk-averse.
The trade-off
Many a wise person has shared the wisdom to the effect that “if you want to achieve lofty goals, you have to take some risk”. Usually, the goal is compelling and rewarding enough for us to willingly take on the risk. However, we think of ways of mitigating the risk through some kind of damage control so that we don’t end up suffering if the risks were to materialise
For instance, let’s say our team is batting second in a one-day cricket match where the opponents have set us a very demanding target of scoring 400 runs in our allotted overs. If our team just scores singles and doubles, it might be safe, but we will fall dramatically short of achieving our target. By taking no risk, we might conserve wickets, but we are almost sure to lose.
To achieve this lofty goal of scoring 400 runs, our team will have to take risks. We will have to swing for the fences. Only then can we have some hope of reaching our target. In summary, scoring 400 runs — or earning a high return — while taking no risks is going to be almost impossible.
The same is true for investing. Earning a high return but while taking on very low risk is not possible. It’s a balance that even world-class investors struggle to achieve. Investment history has shown that you just cannot have it both ways — you generally get high returns only when you take higher than usual risk.
Take calculated risks
Exposing oneself to risk is not something one should do blindly. It must be done in the context of what the expected pay-off might be. If the reward is compelling enough, then it probably makes sense to take on the risk. Otherwise, it is not worth it.
Let’s take an example from everyday life. Wearing a seatbelt while driving is compulsory. Yet, many of us choose to drive without fastening our seatbelt. This exposes us to numerous risks. However, taking on these kinds of risks has very little upside or payoff, but clearly disastrous consequences if the worst were to happen. This kind of a risk, which has no upside, is not worth taking.
Contrast this with the batsman chasing 400 runs who tries to hit every other ball to the boundary, with a degree of power and placement. Sure, there is a risk of getting caught, but this risk is probably one that is worth taking because the payoff of scoring a six and chasing down the target is rewarding enough. The big takeaway here for all of us here is that risks should only be taken when there is an upside and the expected payoff is rewarding enough. This is a lesson we must remember when investing our money.
Risk across the spectrum
Let’s take a look at common investment options and their risk-reward trade-offs. The following will help illustrate how we, as investors, expect higher returns as the risk associated with the investment increases.
Let’s say, I have `10,000 to invest in a fixed income instrument, an instrument that will give me a fixed return that is pre-set at the time of making the investment. I am considering three options: Investing in a fixed income security issued by the government or a government-backed entity, investing in an FD issued by a bank, or investing in an FD issued by a company. The government security will pay the least amount of return — the reward — because it is the least risky. It is backed by the government, and all things being equal, the government ought to be a safe party to loan money to.
The bank FD will pay a slightly higher return because the government guarantees only part of the deposit. So, there is the risk of the bank failing, even if it is a very small risk. However, the company FD will pay the highest return because the risk perceived in lending to the company is the highest, so we expect a slightly higher reward for it. What we are trying to demonstrate is that as the riskiness of the investment increases, so does our expectation of return. As a corollary, if we set out to earn a high return, please recognise that this will come at the cost of taking on a higher risk. The above graphic shows some common investments and their riskiness.
No pain, no gain
For those who frequently go to gyms, the idiom “no pain, no gain” is probably a familiar one. In the investment world as well, if we want gains, it’s going to be possible only when one takes some risks. Almost every investment option involves taking on some risks.
Taking risks, albeit in a calculated manner, is something that is advisable, depending on one’s personal situation. Just like not everyone has the capacity to lift weights of up to 40 kg in the gym, not everyone has the capacity to take on high risks. You must take on risks according to what your risk appetite allows you to do, and what you feel you are comfortable about.
So, the next time you are looking to invest money, do keep in mind that there will be “no gain without pain”. Be realistic and don’t expect to get high returns unless you take on some risk.
Regardless of the type of investment, there will always be some risk involved. You must weigh the potential reward against the risk to decide if it's worth putting your money on the line. Understanding the relationship between risk and reward is a crucial piece in building your investment philosophy. Investments—such as stocks, bonds, and mutual funds—each have their own risk profile and understanding the differences can help you more effectively diversify and protect your investment portfolio.
Carrying Risk
While the traditional rule of thumb is “the higher the risk, the higher the potential return,” a more accurate statement is, “the higher the risk, the higher the potential return, and the less likely it will achieve the higher return.” To understand this relationship completely, you must know what your risk tolerance is and be able to gauge the relative risk of a particular investment correctly. When you choose to put your money into investments that are riskier than a standard savings or money market deposit account, you run the possibility of experiencing any or all of the following to some degree:
Losing your principal: Individual stocks or high-yield bonds could cause you to lose everything.
Not keeping pace with inflation: Your investments could rise in value slower than prices. This is more likely to happen if you invest in cash equivalents, like Treasury or municipal bonds.
Coming up short: There is a real chance that your investments don't earn enough to cover your retirement needs.
Paying high fees or other costs: Expensive fees on mutual funds can make it tough to make a good return. Beware of actively-managed mutual funds or ones with sales loads.
The Different Risk Profiles
Three main investment vehicles are readily available to most investors: stocks, bonds, and mutual funds. Some of these carry more risk than others, and within each asset class, you'll find that risk can also vary quite a bit.
Stocks
Most people have stocks in their investment portfolio, and for a good reason. According to Ibbotson Associates, stocks have reliably returned an average rate of 10% annually since 1926. This is higher than the return you're likely to get from many other investments, especially less risky ones such as bonds. However, be cautious with stocks. You could buy stock in established, blue-chip companies that have a fairly stable stock price, payout dividends, and are considered relatively safe. Or, you could choose to invest in smaller companies, such as start-ups or penny-stock firms, where your returns are much more volatile.
Bonds
A popular way to offset some of the risks from investing in stocks is to keep a certain amount of your money invested in bonds. When you purchase bonds, you're essentially lending money to a corporation, municipality, or other government entity, depending on which bonds you buy. Bonds generally provide more safety than stocks and are given a rating from agencies such as Moody's and Standard & Poors. Ratings act like a credit score or report card, and AAA-rated bonds are considered the safest.
When you buy government bonds, you receive a guarantee from Uncle Sam that you'll get your money back plus interest. At the other extreme are junk bonds, which are sold by corporations. Junk bonds promise much higher returns than long-term government bonds, but they're high-risk, and in some cases not even considered investment-grade securities.
Mutual Funds
Mutual funds make sense for many investors because they're managed by professional portfolio managers so that you don't need to worry about watching the market or monitoring a stock portfolio. Mutual funds work like a basket of stocks or bonds, and when you buy shares of a mutual fund, you get the benefit of the variety of assets held within the fund.
You can choose from a wide variety of funds with different risk profiles. Some hold large-company stocks; some blend large- and small-company stocks; some hold bonds; some hold gold and other precious metals; some hold shares in foreign corporations; and just about any other asset type that comes to mind. While mutual funds don't completely take away risk, you can use them to hedge against risk from other investments.
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