In 2015, I happened across the Financial Independence Retire Early (FIRE) movement. I wasn’t actively looking for direction in our financial life, but I had been living with a vague discomfort that we could be doing more. FIRE galvanised me to once again take control of our money.
In 2016 we tracked spending, and saved an emergency fund. The next step was beginning to invest – but how? The idea of investing was scary. There are so many options, traps and pitfalls for the unwary that I wanted to be fully prepared before we started. This series of posts is about the resources we used, and the steps we took to ensure a level of comfort before diving in. Mr. ETT and I sat down once each weekend to work through these steps together. At the end of each post, there is a link to the resources we used.
In Part 1, Mr. ETT and I defined our reasons for investing, our goals for the future. This time, we sat down to think about risk, volatility and timescale.
Risk is the chance of suffering a loss. Human beings take risks every single day. The important issue is to understand the risk – what will be gained or lost by taking the action? Is the gain worth the possibility of a loss? When pedestrians cross against street lights, they are weighing a number of variables: Is this a major road? Are there any cars coming? Am I fast enough to beat the cars? What is the likelihood that the lights will change soon? Is the intersection being targeted for jaywalking? If they are crossing a 6 lane 110km/hr highway in peak hour, the risk is major. If they are crossing a side street in a tiny town at 3am, the risk is minor. Either way, hopefully they have considered the variables above, and made an informed decision on the action they wish to take.
Risk Tolerance is about your emotional ability to cope with loss – in the case of investing, specifically financial loss. Like many things in life, it can be difficult to imagine the true depth of your feelings under any given circumstance, or to know for sure how you would react. Before beginning to invest, attempt to identify how you would feel if you lost money, and what you would be likely to do. Would you sell everything regardless? Or would you stay the course? Does your likely action change depending on the amount of the loss? How much could you take? By thinking about your risk tolerance before you find yourself in the situation, you are attempting to minimise your risk when investing.
Risk Capacity is about your financial ability to cope with loss. Just how much can you afford to lose? Imagine the difference between you and Bill Gates (currently the richest person on the planet, with $86 BILLION – why can I never say this number without the Dr. Evil accent?) For the purposes of this example, you decide to invest everything you own. That’s right – your entire net worth (you’re reading this blog post, so we know you would never do that). Bill Gates matches your amount in the same investment.
Now imagine that the investment goes belly-up. You have lost every. single. thing. Your life has changed immeasurably. Bill Gates has lost … actually, no. In the time it took to type this sentence, his money has made money and he’s now right back where he started. For that amount of money, you have a low capacity for loss, whereas Bill has a high capacity for loss. When investing, you need to determine just how much you could afford to lose, and beyond that – how much would you be willing to lose?
Volatility is change that occurs rapidly and unpredictably. When talking about investments, it is a measure of how far the investment deviates from its average. Both the high and low volatility investments below demonstrate an average profit of 5% at the end of the year. Not a great return, but way better than an everyday bank account.
However, look at August. If you were invested in the green investment, at that point in time, there is a (paper) gain of 50%. Hooray! But what if you had planned on taking your money out and retiring in July? You were relying on a 5% average return, but there is a (paper) loss of 50%. Ouch. No retirement for you. Note how I said (paper) loss? As Pete points out, a loss is only a loss if you take your money at that point. Until you take your money out, the loss isn’t realised. In this scenario if you held on for one more month, your loss suddenly becomes the best gain of the year. But only if you take out your money at that point. It works both ways.
How long do you have to invest? When will you need your money? By looking at your reasons for investing you should have a fair idea of the date you will need your money by. Note that you don’t need a single timescale for your investments. As per our last post, we have broken our goals into
- Short Term (1 -2 years)
- Medium Term (3 – 5 years)
- Long Term (5 – 20 years)
- Retirement (>20 years)
The shorter the investment period, the more risk you are likely to encounter when investing. If your investment time period is less than 3-4 years, you are probably better off finding a high-interest savings account and keeping your money in the bank. Whereas, the longer you hold an investment for, the more likely it is to meet its long-term average return. Investing is a long-term process. You can’t try to time the market, you just need to let time work for you smoothing out the process.
Also, simply by the virtue of being in the market, your timescales will eventually change. If you are starting out, and investing for retirement when you are 20 years old (good for you!) you have a decades long timescale. But as you slowly build up your nest egg and approach the time you would like to begin to use it, then your timescale becomes short. For example, when a massive market downturn happens (and it will!). If you are 20, you have time to stick it out, and 5 or 10 years later you have hopefully recovered and thrived. But if that market downturn occurs 2 years out from when you plan to retire, you no longer have the timescale capacity to recover losses. (Luckily you have an investment plan in place and had reduced your level of risk in line with your timescale.)
Risk, Volatility and Timescale
So choosing where and how to invest becomes a balance between levels of risk, volatility, and timescale. Perhaps, if you have a longer timescale, you can accept a higher level of risk and more volatility. The closer you come to reaching your goals, the less risk you want, so probably also lower volatility. Had a sudden life change (birth, death, marriage/life-partnering)? You need to review your risk tolerance, capacity and financial goals.
There are so many risks when investing, it could take pages to describe them all. This can be so off-putting for new investors, that you may choose not to take any action. The thing is, this is a risk in itself! Yes, it is titled inertia risk, which is the risk that you will suffer a loss by not doing anything. How can that possibly be a risk? The current environment is the perfect example. If you decide to keep your money in the bank (a very low-risk environment), earning a paltry 0.1% interest, then over time you will lose out. Why? Because inflation is greater than the return on your money. If you have $1,000 in the bank earning 0.1%, then after 10 years you will have $1,010 (big whoop!). But if inflation is 1.5%, then the spending power of that money is only equivalent to $870.32.
Don’t be disheartened – take some time to understand what the risks are, and whether or not they even apply to you. Pete Matthew identified 4 main risks when investing:
Inflation – reduces the buying power of money. Inflation works against you, which is why you need to consider investing to increase the buying power of your money for the future.
Longevity – if you live too long and your money runs out. Living too long is a good outcome of risk, but you need to manage your money and investments to ensure that you are living well.
Inertia risk – if you do nothing you could miss out. Doing nothing is a risk in itself. I had no idea that this was an issue, but now it’s been explained I can see why I have to press on with learning to invest.
Investment risk – risk of financial loss. The value of your money may go down. As a new investor, this is the type of risk I am most familiar with, and most concerned about.
After all this talk of potential losses, why would anyone take the risk of investing? Because there is a link between risk and reward. Unfortunately it isn’t linear. No-one can say “if you take x level of risk, you will receive y reward every time.” Risky and volatile investments MAY give rise to higher returns. Knowing about the potential risks will allow you to take steps in order to minimise them. You can then use risk, volatility and timescale to your advantage.
Next post we will be looking at identifying our Risk Profile.
The resources we used to help us begin to invest step by step.
Meaningful Money Podcast, Season 2, Episode 2: Risk, Volatility & Timescale
ASIC’s MoneySmart – Investing Between the Flags