What Are The Risks & Rewards Of Investing?
Investing is often considered to be far too risky and that it can completely decimate your hard- earned savings. I’m not going to tell you that this is a myth, as frankly, sometimes it can. That is, if you don’t understand the rationale behind risk.
"Depends on your attitute to risk and how much you are willing to risk."
I want you to understand that there is no such thing as ‘no risk’. If we look at a jar of coppers as an example, the amount of money you’re collecting is being affected by risk every day. No, it’s not directly Stock Market risk, but it’s risk all the same.
The best analogy I can use here is chocolate. When I was a teenager in the 1990s, you used to be able to buy a Cadbury’s ‘Chomp’ for 10 pence. If I went to buy that same bar of chocolate today, I’d be lucky to find it for less than 20 pence. Not only has it doubled in price, but it’s actually shrunk in size: it costs more and you get less. What’s happened here is inflation. The worth of my money has decreased, so I can buy less with it.
That jar of coppers will gradually become worth less and less as time progresses. It’s not receiving a rate of interest, so it will never beat inflation. The same can be said for any money sat in the bank that is receiving a rate of interest lower than the rate of inflation: that can include your savings accounts, Cash ISAs especially where the introductory offer has expired and at the time of writing, all current accounts.
As an example, at the point of writing, the best accessible Savings Account I can find on a comparison site is offering 1.1% interest per annum. The current rate of inflation on the goods you buy is 3.5%. This means even if you have chased down a good savings account, you are guaranteed to lose 2.4% of your money every year this continues. Yes, you read that right, guaranteed to lose 2.6%. And whilst I accept is a relatively high example, almost without exception you would have lost money every month for the past 10 years! If that had been the inflation and savings rate across that 10-year period, £10,000 of your savings would now only be worth £7,843!
As a caveat here, I would like to point out that it is generally a good idea to keep some money in cash for day-to-day expenses and emergencies, so you certainly shouldn’t be thinking about investing all of your money.
So, you are always taking risk, but there are different types. To receive growth, and allow Compound Growth to work it’s magic, you do need to take some pre-defined risk with your savings. When it comes to your money, especially your saving strategy, you must feel confident and secure that you are doing the right thing. A good Financial Planner will conduct a Behavioural Risk Assessment before you invest, to understand your appetite towards risk, as well as how much you can afford to lose. Before you invest, make sure that you know your unique score.
Once this has been defined, you can then look at how much you need to achieve to meet your goals. There are a variety of tools and techniques, which I will cover in my next book about planning your future. However, for now, I just want you to understand that you need to calculate your Financial Security Number (i.e. the amount you will need to be able to reach the expenses for the rest of your life) before you can begin to decide upon your level of risk. Your Financial Security Number can be simply calculated as follows:
Expenditure – (Passive Income, like rent) x25
It is important to consider that with a Financial Security Number, your income is almost irrelevant- it is your expenses that count. For example, if you earn £100,000 each year you have a high income. But, if you spend £90,000 per year that money would not last very long.
The calculation provided here is by no means exact, but it will give you a good indication of what you should be aiming for. At Efficient Portfolio, we adopt a more sophisticated approach to calculating this number, using a tool called a Lifetime Cash-Flow Forecast, which illustrates the levels of wealth you will need to live out your unique goals. The Lifetime Cash-Flow Forecast enables us to hypothesise different scenarios and tailor expenditures on a year-by-year basis, rather than calculating how much you will need on a flat basis.
Once you have your assessment result and your Financial Security Number, you can work out if you can afford to take less risk to achieve your goals, or if you are comfortable in taking more. Generally speaking, the more risk you take, the higher the returns, but you can also often suffer the greatest losses. Remember, your investments should only be set at a risk level you are comfortable with. As Pound Cost Averaging shows, slow and steady can still win the race, if invested correctly.
To calculate how much risk you can afford to take yourself, you need to work on the premise that you will get an income from your investments plus inflation from your invested capital. For example, if you invest your money with a relatively high level of risk, and could expect a 5% rate of return plus inflation returns, then you need to multiply your figure by 20. If you are more cautious, therefore expect a rate of return of 3%, then you multiply by 33.
Over time your tolerance to risk will change. There will be periods in your life where you need to be more guarded with your wealth, and times when you can take more risk to build higher gains. Equally, market fluctuations will, overtime, make the level of risk on your investment increase. In both scenarios, it is important to ‘rebalance’ your investment portfolio, so it never becomes more or less risky than you want it to be. In the 5th book in this series I will talk about the importance of reviewing your investments, but for now please understand that it is a habit that all successful investors follow, and is pivotal to you securing financial freedom and the future you want.
