What is risk in investing?
In contrast to bank savings accounts¹, there are risks associated with most investments. Taking risks is a necessary step in order to target higher returns than what you earn with a bank savings account².
This means your investment might achieve a return below target or even result in a loss. The opposite is also true- when taking risks, there is a chance that the return on your investment exceeds the target.
Has it occurred to you that we are taking risks in our daily lives?
We plan a trip to the beach hoping that it wouldn’t rain (the weather forecast can only do so much), take the train assuming that it wouldn’t break down, and try the new flavour at the bubble tea store convinced that it will taste good.
When it comes to investment, we look back at our experience and understanding of investment topics to help us weigh the risks in investments. We may also turn to past data and listen to financial gurus to evaluate the possibility of our investments doing well, or whether the returns will be less than what we hoped for.
While we have the definition in the box above, in reality, everyone understands and evaluates risk differently. The end goal is to achieve a return in line with one’s financial objective while minimising the potential losses caused by market fluctuations.
What is a risk profile?Each individual has a unique risk appetite that is different from one person to the other. Your risk profile is then a gauge of how open you are to taking financial risks. It depends on your personality (risk appetite), goal of investing, financial situation, lifestyle, and age (which affects how much time you have to recoup losses).
How are risks measured?
While financial experts use a large variety of indicators and analytics to define investment risks, non-professional investors typically focus on potential losses and the probability of such losses happening.
For instance, when investing in global equities, there is a 13% chance that investors lose more than 10% over a full calendar year³ and there is a 60% chance of annual gains above 10%. Such an investment strategy historically generated substantial long-term returns, about 9% p.a.
That 13% chance of losing more than 10% in a calendar year is the risk that equity investors have to accept in order to benefit from high returns offered by this asset class in the long term.
What you need to know about risk management:
1. The level of risk and returns are usually matched
Based on the logic of the risk-return tradeoff, a higher-risk investment is usually compensated by a more attractive expected return. On the other hand, lower-risk investments tend to reap more modest gains.
However, there is also a flip side. Low-risk investments are, in a sense, safer – less likely to incur losses, while higher-risk investments can be subject to greater potential losses.
What this means for you, is to consider whether you can sustain short-term losses before any investment is made. To know your risk, consider your current financial standing, what your financial goals for the future are, and your risk appetite.
Some may be happy to take bigger risks, while others may want to minimise risk.
2. Risk is linked to how long you invest
Usually, those who invest for a longer period of time can afford to take more risks. This is because they have the time to tide through short-term drawdowns, ups and downs in the market, and potentially negative returns for months (or even years, in the case of the riskier investments) before they start seeing returns.
For a 25-year-old investing to set up a retirement fund by 60, he has 35 years to do it.
For a 45-year-old in the same situation, he only has 15 years.
The 25-year old can afford to take more risks in growing his wealth because he has a longer timeline. If he were to make a loss, for example in the first 5 years, he would still have 30 more years to recover that loss.
On the other hand, the 45-year old investor does not have as much leeway in taking risks. This is because the 15 years to grow his wealth would not provide as much time to recoup potential losses from his investments.
3. No investment is 100% free from risks
Low risk doesn’t mean no risk!
When it comes to investing, even the most stable options have a small amount of risk involved. There is a large variety of risks: market risk (as a result of changing economic and market conditions), liquidity risk (as a result of a lack of market transactions), credit risk (bankruptcy risk for corporations and for countries), geopolitical risk, regulatory risk, operational risk and more.
Fixed-income securities (that is, money-market securities and bonds), while are generally considered the most stable asset class, may still have price fluctuations as a result of changes in interest rates, the changing market sentiment towards credit risk, or the currency fluctuation.
Although risks are unavoidable in investments, we completely understand that it can be uncomfortable. That’s why we’ve constructed a portfolio that is less sensitive to market shocks.
For example, when you sign up for Earn+, we place your money in carefully selected funds that only invest in very specific instruments: cash, money market, and short-term investment-grade bonds (investment-grade bonds are bonds that are more highly rated by credit rating agencies, and are believed to have a lower chance of defaulting).
While Earn+ may seek international diversification, it does not seek currency risk and the exchange rate fluctuations have a negligible impact on the portfolio returns.
Ultimately, this reduces the risk your investments would be exposed to while seeking to maximise the returns you would receive.
4. Diversify your portfolio!
Is there such a thing as a free lunch?
Nobel prize winner Harry Markowitz famously mentioned, “diversification is the only free lunch in finance”. It’s so true because not only is portfolio diversification inexpensive (through the use of mutual funds, for instance), it’s also the best strategy to mitigate risks. Diversification allows your portfolio to have lower sensitivity to company-specific or sector-specific shocks, which does wonders in helping you ride through fluctuations in the market.
Diversification does not necessarily increase the expected return on an investment portfolio, but it usually dramatically reduces the risk of severe drawdowns.
Everyone’s definition of “risk” is different. It depends on one’s personality, risk appetite, reason for investing, and how much they are willing to put on the line.
Don’t just take anyone’s word for it when they say buying a particular asset is “safe”. A little research goes a long way. Do a little legwork to understand if the risk matches your appetite, before diving in.
Is saving more one of your financial goals? Get started effortlessly with Earn+. It helps you build a saving habit while earning 2 to 2.5% interest rate p.a*.
*Projected yield and returns are not guaranteed or protected
¹The Singapore Deposit Insurance Corporation (SDIC) insures bank deposits of up to $75,000 per depositor per member bank. Even so, this insurance does not preserve the buying power of these bank deposits against inflation.
² Bank savings accounts are currently earning around 0.05% per annum.
³ Empirical study based on MSCI World index data since 1970. Source: GrabInvest and Bloomberg.