Learning About Risk
Are you risking enough for your desired returns?
Life is about trade-offs. So is investing.
The investment trade-off is between risk and return. Let’s start by grasping the nettle. Getting a reasonable return – indeed any return - on your investment means accepting risk of some sort. But what, exactly, is risk? And how much of it can you tolerate?
The Two Risks You Face
First, there's the risk of losing money over the short term. Over the last 80 years, the stock market has returned around 10% per year, on average; however, looking at individual years over that time period, about one out of every four was a down year in the market. And over shorter time periods--a few weeks or months--investments can be even more volatile.
Investors focus almost exclusively on this type of risk. It's easy to do. Every day you hear about how the market is doing on the radio and television. And if that's not enough, you can check your stock prices throughout the day.
The problem with volatility lies primarily in the fact that it can encourage the uninitiated investor to make “knee jerk” reactions to short-term events. The world is full of saloon bar “experts” who ploughed money into technology stocks in the good times and then “knew exactly” when to pull out, i.e. in their case, after the market had collapsed! The truth is that, to the long-term investor, volatility (which of course can be upwards as well as downwards) is irrelevant. The important issue is to follow a strategy that provides the best realistic prospect of achieving your goals – and by doing so, to avoid following the investing fashion of the moment, whether that be a fashion for selling or buying.
Thus, an unhealthy obsession with volatility and so-called short-term risks often means that you'll virtually ignore the second and perhaps even greater risk that comes with investing: the risk that you won't meet your goals.
Evaluate Your Long-Term Goals, not the Market's Short-Term Volatility
How can obsessing about volatility get in the way of your goals? First, it may cause you to invest too conservatively. What’s the benefit of being “safe” if it simply guarantees that you won’t have enough money to retire on? Volatility also may lead you to buy or sell an investment based on short-term performance rather than on how this purchase or sale will help you reach your goal. In short, volatility can prevent you from seeing the forest for the trees.
Thus, the crucial conundrum is to weigh how important reaching your goal is against how much short-term volatility you're willing to accept.
Working with a financial adviser will help you assess realistically and constructively your attitude to risk and how this should be reflected in your investment approach. Bear in mind that experience suggests that more people run the risk of failure in their investment planning by taking too little risk than by taking too much. As with many aspects of our lives, it’s important to find the right balance, in investment terms, between the risk of losing money and maximising return. This will vary from person to person and situation to situation.
The main lesson is don’t shy away from “risk” as being automatically a “bad thing to be avoided at all cost”. Life is, after all, full of risks, from crossing the road to playing the gambling tables at Las Vegas. Understanding the nature of those risks and what they mean to you will help you plan your investments sensibly and thereby meet your financial goals.
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