When it comes to investment, we all want the same thing: lots of money without any stress!
But we can’t always get what we want. That’s because there’s an inevitable trade-off in investment between risk and return. In order to increase our expected returns we have to be prepared to take on more risk.
To put it another way – a higher return is our reward for accepting more risk.
I think there are a few things we can do to tilt the playing field in our favour in this trade-off. But first it helps to ask what exactly we mean here by ‘risk’.
What risk really means
It’s an important question to ask – and the answer isn’t as obvious as you might think. Because when we’re talking about investing, the word risk has a very particular meaning.
In investing, the word risk doesn’t mean danger, like the risk of running across the road without looking, or the risk putting our life savings on the 3.30 at Ascot.
For an investor, risk means just one thing: volatility. Volatility measures how much the price of an asset goes up or down. So, for an investor, the word risk means the amount you can expect the price of an asset to vary in the future.
That’s why, for example, US Treasury bonds aren’t considered risky. Their price doesn’t change much. The price of a stock moves around much more than a US Treasury bond – hence, it’s more risky.
So, risk means volatility and a higher return is our reward for accepting more risk.
That’s why stocks pay more than bonds over the long run. The price you pay for that is the extra volatility – there will be periods when you are going to be a bit poorer than you hoped, and others when you’ll feel a bit richer.
How much risk is right?
So, how much risk should you take? Well, it’s all about that trade-off between volatility and returns. If you can live with bigger swings in the value of your portfolio, and if you can afford the potential losses, then risky assets are the one for you. They’re the ones which make the biggest returns.
If you’ve been investing in penny shares for a while, you’ll know all about this. The wins are big, but so are the losses. Me, I’ve had some uncomfortable losses over the years, but these have only been temporary setbacks because I stayed with the market. And if you can be unemotional and add to your position during those downturns, so much the better.
Our investment strategy shouldn’t be like that like that 3.30 race at Ascot. It’s about watching our wealth build over a number of years – and not being blown off course by a short-term blip.
I’d argue that the real risk, that of suffering permanent loss, comes from selling out of equities at a low and not getting back in. Investment risk – or volatility – is something that you should learn to live with.
My opinion on this isn’t particularly popular in the investment world. A vast network of highly-paid professionals makes its money advising people to trade big and often. It’s just not in their interests to advise that investors do the opposite – buy and leave alone.
If you want to build as much money as possible over the long-term though, it’s clear what you have to do. Risk on!