I’ve taken plenty of risks in my life. Some were productive, like packing up and moving to London. Leaving my marriage was a big risk that was hard to take, but the right thing to do. Wearing neon patterned tights with a crushed velvet skirt to a mufti day in year 7 – that risk did NOT pay off in either social or fashion terms.

When it comes to money, you need to get comfortable with risk. You see, there is a thing called the risk-reward premium, which means the higher the risk, the higher the (potential) reward.

This also means you can put a price on risk – the riskier the deal, the higher the stakes.

It’s why a car loan has a much lower interest rate than a credit card. The car can be repossessed if you can’t pay back the loan, while the credit card is ‘unsecured’ – they can’t come after you for the delicious cocktails you just bought, and the bank manager won’t fit into that Kookai dress. So the risk is higher for bank and more expensive for you.

Risky Business?

Now I am not saying let’s go to Vegas and put it all on black.

But when you invest, you want to balance the risk within your portfolio and within the asset class so that you get a good return while not losing your money.

Ok wait, I just dropped some jargon there. Let’s break it down.

Your portfolio is your entire wardrobe.

Your asset classes are each section: shoes, dresses, underwear, activewear, etc.

We talk about being ‘underweight’ or ‘overweight’ certain types of investments. For example, when the banks aren’t performing well, you might sell off some of those stocks and become underweight in banks. Or if you think resources are about to get hot again, you buy more and go overweight.

This can apply within one asset class – so you can be overweight on running shoes and underweight on high heels, within the broad ‘footwear’ asset class.

Or it can apply to the broader asset classes, so you have heaps of activewear, but not much in the way of work clothes (yep, me). That would be like having a lot of property (your own home) but only a small parcel of shares.

So now we have the lingo, let’s talk about risk. Here’s what you need to know:

1. You need some risk in order to make money, and that’s ok.

2. You can manage that risk by spreading it around – aka diversification

Now let’s talk more about that.

Why risk is ok.

Risk is what makes you money. It’s the old adage of ‘nothing ventured, nothing gained’. So it’s safe to keep your money in a term deposit in bank, but that’s not going to make you money.

In fact you could even lose money in the bank.

Wait, what?

Thing is, there are heaps of different risks when it comes to money, and one of them is inflation risk. You know how a bag of lollies used to cost 20 cents when you were a kid, and it’s $2 now? That’s inflation.

The value of money changes over time (it’s a really complicated backstory as to why), but let’s just say, inflation usually runs around 2-3% per year. (It’s lower than that right now, but has often been 5-6% in the past 30 years).

If your money is in the bank getting 2% interest, and inflation is 2%, you aren’t making money, but you’re breaking even. But if inflation goes up to 2.5%, you’re actually losing money. The dollar you put in buys less than what it bought a year ago.

This makes intuitive sense right? Things cost more all the time.

So that’s called Inflation Risk, and it’s a risk you face even when you think you’re not facing a risk. Crazy huh.

Here are some other fun and friendly risks:

Interest Rate Risk – The risk that interest rates will change and affect your investment. For example, you buy a property at 5% interest from the bank and then interest rates go up. Suddenly, the $2000 a month mortgage that was covered by rent becomes $2200. Not only do you have to find more cash, it changes the yield – i.e. the return you’re getting for the money you spend.

Liquidity Risk – The risk that you might not be able to turn your investment into cash as quickly as you need to. In the example above, you decide to sell the house as you can’t cover the repayments. But a bunch of other people have been hit by rate rises and are selling too. And with home loans more expensive, the number of buyers falls. So you might have the house on the market for several months, even drop the price. The property investment has low ‘liquidity’ and it can cause all sorts of headaches.

Market Risk – You can be the best stock picker in the world – or pay the best stock picker – but if the whole market falls, it’s pretty likely your investments will fall too. Economies – and the markets they’re part of – are always cyclical. They go up and down – that’s as much a part of life as the fact that you’ll get your period on the exact day you don’t want it to come.  The trick is to be prepared for the cycle and have diversified your risks – that way you can manage the dips when they come.

This is just a short list to give you a flavour. There are plenty more, like

  • sequencing risk (the risk that your investments are in the toilet right at the time you need them);
  • credit risk (the risk that the company you lent money to – in the form of bonds – goes under and doesn’t pay you back);
  • operational risk (the risk that you invested in a company run by morons who bugger it up and lose your money); and
  • concentration risk (the risk that you put all your eggs in one investment basket and then drop the whole darn basket).

You can make friends with risk

I’m not trying to scare you though. You don’t avoid investing just because there are some risks. If I listened to my mum about all the risks of going on holidays to the US (being shot, getting raped, the plane crashing, the car crashing…) then I’d never go.

What you do is manage risk, by being clear about your time horizons and your goals. (A financial adviser can totally help you there).

The rule of thumb is that you only invest in shares if you have at least a five-year horizon, because that’s how long you need to smooth out their ups and down (technically called volatility).

An investment property generally needs even longer because of the costs and drama associated with buying and selling.

And with your superannuation, you have 30-40 years to smooth out the returns, so if you’re young (under 45 or so) then you can tolerate even more risk in the hope of getting higher returns.

Spreading the risk is crucial. The ideal (possibly over your lifetime) is to have a bit of everything. Not just a property, not just shares, not just a term deposit, not just bonds. A bit of everything.

But you can start small. For example, think about a managed fund or ETF if you already own your home. Think about buying listed property instruments (REITS) if you already have shares but can’t afford an investment property.

Basically, don’t just buy a bunch of super cute high heels but then never have any good flats you can walk in.

Risk in a nutshell

So here are the takeaways you should know about risk:

Risk is a part of life, and investing. But if you stay away from crazy, get-rich-quick, too-good-to-be-true investments, you can tolerate and manage risk effectively.

There is also risk in doing nothing. Letting your money sit there and track inflation is a risk, because you risk your future returns and wealth.

So don’t be scared of risk – because the other side of it is reward. Imagine if you never took the risk of drinking too much, wearing too little and partying too hard – what fun stories would you have to remember? Investing is just like that, but with less booze.

Photo credit: Aaron Perkins