Not understanding risk is the biggest risk
It’s a noun: a situation involving exposure to danger, harm or loss. It’s also everywhere. Without risk nothing would change. We’d never move forward.
Don’t fear risk. Get to know it, understand it, and use it to achieve your goals.
There is risk in investing
It’s impossible to predict the future, but over the long-term stocks have delivered better returns than cash. Here’s a graph that shows the percentage of times during the last 116 years that shares have beaten cash when held for 5, 10 and 18 consecutive years.* Over a period of 18 years shares delivered better returns than cash 99% of the time, over 10 years they delivered better returns than cash 91% of the time.
Despite this, there were a lot of ups and downs along the way. On average in the US there was a market correction (a drop of between 10-20%) every year since 1900. And a larger crash (a drop of 20% or more, also called a bear market) happened every four years on average.
Whilst these feel very bad at the time, 100% of corrections and crashes throughout history so far have been followed by a recovery that more than makes up the losses. Arguably then, the real ‘risk’ of investing is being forced to sell during a correction or crash before they have time to recover. The key way to avoid this risk? Simply don’t invest money that you may need access to in the shorter-term.
There is risk in not investing
It’s true that if you keep your money in a savings account you have more certainty about the interest rates you’ll get. It’s very unlikely though that the interest you earn will match inflation so the purchasing power of your money declines each year. For example, with inflation currently at 2.5% and interest rates below the Bank of England base rate of 0.5%, you ‘lose’ 2% each year in purchasing power, or one fifth every 10 years. Here’s an example of what would have happened to your £10,000 below if held in a savings account between 2008 and now. The nominal value of your money goes up over time as (in blue) as interest is added– you’ll see your £10,000 edges towards £11,000. However, the real value (what you can actually buy with that money) goes down as the result of inflation (in red) which overrides any interest you may earn. Ultimately you end up being able to buy less with your money over time.
Time horizon is the key
- In the shorter term, you accept purchasing power decline of cash for the certainty of outcome.
- Over the longer term, you accept short-term volatility of stocks for the potential of protection against inflation.
Quiz: How can you lower your risk?
1. Hide your money under your bed
2. Invest for the long-term, and don’t sell when there is a downturn
3. Keep all your money in a savings account
- What are your saving and investment goals? Shorter-term or longer-term? This will help you determine what type of investment you need
- Allocate more into cash for shorter-term purchases (e.g. holiday, rainy day)
- Allocate more into stocks for longer-term
- You can make any adjustments to your allocations in app under Settings>Allocations
*Source: Equity Gilt Study 2015. Past performance is no guarantee of future performance.
Quiz answer: 2
All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest. Past performance is not a reliable guide of future performance.