What is risk anyway?
12 April 2021
Different investments have different levels of risk. Some investments are higher risk, which can mean the odds of you losing some, or all of your initial investment are higher. And other investments are lower risk, which can mean that the odds of you losing some, or all, of your investment are lower.
But what does this mean in practice? What’s the difference between low-risk and high-risk investments? What is risk anyway?
Let’s take a look at these questions and sort out what risk is, what to you might look for, and how to manage it.
What is risk?
We usually think of risk as the odds of losing something, but in investing, it’s a bit wider than that. Risk is the chance that you won’t get the returns you hoped you would get. This could mean making a lower return than you expected, no return at all, or even losing the money you invested in the first place.
Here are a couple of extreme examples: if you bought a safe and put your money in it, you would be taking very little risk. You would expect your returns to be exactly 0%, because your money’s just sitting there. It’s not invested in anything. But you could also rely on those returns being 0%.
On the other hand, imagine buying a lotto ticket. When you buy a lotto ticket, you’re hoping to win millions of dollars. But we don’t need to tell you that the odds of that happening are very small. Walking away with nothing is a lot more likely than winning big. So that means a lotto ticket is very high risk.
In the investment world, a low-risk investment is generally something that generates stable, relatively dependable returns, with a relatively low likelihood of losing some or all of your initial investment.
Putting money in the bank is an example of a low-risk investment: the bank pays you a fairly low interest rate, but in exchange for that, it offers relative safety. The odds of your bank going bust and defaulting are very low.
A high-risk investment differs as it’s generally less stable. It may give higher returns, but it also may not deliver those returns—in fact, you may be more likely to lose some or all of the money you started with.
The other side of risk
But there’s another side of this equation: the returns. Investments with more risk tend to give you a shot at higher returns (although not a guarantee). But that chance of a higher return comes with a higher chance of not getting that return and losing your initial investment.
Let's look at the returns (and the risk) of a couple of different investments.
Bonds are generally lower risk, but they also tend to have a much lower average return over the long term than some shares—which are higher risk but can give higher returns.
Bonds tend to be stable in price, and pay investors regular coupon payments (like an interest payment). So you can be more certain about the return when you buy into bonds. In exchange for that certainty, you give up a shot at the higher returns you might get from a higher-risk investment.
The reason for this is because bonds are debt while shares are equity. A bond holder is lending a company money, while a shareholder actually owns a piece of that company. This means the bond holders get paid first. When a company makes money each year, it’ll first pay its interest payments (or coupons) to bondholders. Then it’ll decide whether to pay a dividend to shareholders or not (if there’s money left over).
If a company goes under and its underlying assets are sold off, the bond holders will be paid from the proceeds of these sales before the shareholders.
Shares, on the other hand, tend to be more likely to fluctuate in value. And while some companies pay regular dividends, these dividends are not guaranteed. A company may lose money one year, and be unable to pay dividends—or it might just choose not to!
Opportunity comes with risk—and if you completely avoid riskier investments, you are potentially giving up the better returns that higher risks may bring over time. This isn’t a bad thing! If you don’t like to take risks, you don’t have to.
Manage your risk
Risk is not an all-or-nothing proposition. There are some strategies that let you take on some risk, without taking huge risks. Let’s look at a couple of them.
Diversify, diversify, diversify
Diversification helps you spread your risk by putting your eggs in lots of different baskets. For example, if you bought shares in an exchange-traded fund (ETF), you’d get a little piece of lots of different companies, rather than a single company. That means that if one of those companies doesn’t do as well, you still have a bunch of other companies within the same investment that might pick up its slack. Diversification gives access to the returns from lots of companies, without putting all your eggs in one basket.
Of course, this approach only protects you from the risk of one company performing worse than the market in general. You still have the risk of returns from the entire market standing still or going backwards—which is what can happen in a recession or a big shock like the GFC (Global Financial Crisis) or COVID-19.
Some investors will split their money between higher-risk and lower-risk investments. That gives you access to some of the higher potential of the higher-risk investments, while also keeping some of your money in lower-risk investments to balance things out. Or, you can invest in a bunch of companies, while also investing in managed funds and ETFs. This means that some of your money gets the potential upside of one of those individual companies performing better than the overall market, while the rest of your money is more broadly diversified in funds.
You can also diversify by investing in a range of different types of things. For example, you could have some of your portfolio in bonds, some in low-risk bank accounts, and some in shares. Or you can diversify across different regions or industries.
Take your time
Time horizons are another way to manage risk. Your time horizon is the timeframe that you expect to keep your money invested for.
A well-diversified, higher-risk investment tends to go up and down in the short term. However, if you have a long time horizon, you have time for the market to recover before you sell your shares. But you can only do this if you don’t need (or want) that money today or any time soon.
So when you’re thinking about risk, you can manage it by asking yourself when you want to get your money back. If you want it tomorrow, you’re probably better off putting it in a chequing account. If you can wait for a few months or longer, you could consider a lower risk strategy (such as bonds and fixed income). If you can wait for a few years or longer, you might decide to consider a higher-risk strategy.
This is why people saving for their retirement often have more shares when they are younger, then more bonds when they are older, then finally things like term deposits when they actually retire. When you’re living off the money day-to-day, you may value the certainty of a fixed return from a bank, but when you’re investing money that you don’t intend on spending for 30, 40, or 50 years, then you might want to take more risk.
Your risk is your choice
Risk comes down to your goals and what you’re comfortable with. Taking lots of risks can give you a chance of getting higher returns, but with larger odds of losing your investment—especially in the short term. Taking very little risk means you are less likely to lose your investment, but you may get smaller returns in exchange for that lower likelihood of loss.
You might end up somewhere in the middle. Exactly how much risk you take, and how you manage it, is ultimately up to you.
Ok, now for the legal bit
Investing involves risk. You aren’t guaranteed to make money, and you might lose the money you start with. We don’t provide personalised advice or recommendations. Any information we provide is general only and current at the time written. You should consider seeking independent legal, financial, taxation or other advice when considering whether an investment is appropriate for your objectives, financial situation or needs.