Understanding investment risk

For most of us, bungee jumping and skydiving are risky activities. So when it comes to investments we assume a “risky” investment is like those – pretty crazy things that we’d be better off not doing, especially with our hard earned money.

The problem is that in the financial world, this is not what risk means. Investment professionals see risk largely as volatility in returns. “Volatility” is a technical statistical term. It is not anything like the risk of a bungee cord snapping! The important point is that volatile investments have a greater chance of earning superior returns. Avoiding them might be a mistake.

Imagine you were choosing between two holiday destinations. The only difference between them is the weather. At one destination the weather is entirely predictable: it will be overcast and dull, but never rain. At the other destination it is unpredictable – there will be rain but there will also be days of glorious sunshine. On average the you know historically the second destination has had better weather. Finance people will say that the second destination is more volatile and therefore more risky.

This is the sense of risk that we think about when we talk about risk in finance. It is the volatility of returns. In the holiday example, if you particularly hated bad weather or if you only had a few days and didn’t want to risk being stuck in rain, it would make sense to choose the first destination. But if you are not particularly averse to bad weather, and had time to ride out any rainy spells in order to enjoy the sunshine, you might be better off in the second destination.

volatilitygraph

Similar considerations are worth thinking about when deciding what risk you should take in your investments. If you are particularly risk averse in that seeing short-term losses to your investments is something you want to avoid, then you should avoid risky investments. But if you can stomach seeing some volatility, it would make sense to choose investments with more volatile returns. Historically, volatile investments have delivered higher returns than less volatile investments, with the chances of higher returns increasing the longer the investment term.

The rules around tax-free investments mean they are not as risky as other investments you can get in the market. For one thing, investments always involve a portfolio of end products. A tax-free account invested in the stock market, for example, cannot have more than 10% of its exposure to any one company. Tax-free accounts also cannot use leverage and risky derivatives, which lessens their volatility. Only approved providers can offer tax-free accounts.

When thinking about risk it helps to separate your risk tolerance, which is how much risk you are comfortable with, from your risk ability, which is how much risk you can take on given your own financial situation. The ideal strategy is to take on as much volatility as you are comfortable with, and fits your “ability” based on your financial situation. Here are the things to think about in deciding how much investment risk you can take on:

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