What do I need to know about investment risk?

Many people think investing is about knowing where to get the best returns you can earn. But long-term investing is about the trade-off between risk and return - the best returns typically come from taking the most investment risk.

There is also a relationship between risk and time.

This means you need to be aware of the investment risks you are taking, how you can mitigate these risks by staying invested for a certain period and how this period fits in with your investment time horizon. You also need to know if you have the ability to take, and can tolerate, the risk. Read more: What is my risk profile and why does it matter?

Risk in investment is typically defined as the risk of losing money and is often linked to the volatility returns that go up and down over the short term - in the likes of share markets.

There are, however, three risks you should consider:

• The risk of losing money;
• The risk of not keeping up with inflation (losing money in real or after-inflation terms); and
• The risk of not meeting your investment goals.
  
  

The investment risk that will deliver on your needs

The first step you need to take when considering risk is to determine the level of risk you need to take in order to achieve your goals over the time period for which you can invest.

For example, assume you need R10 000 after three years.  You have R500 saved already, and can contribute a further R200 a month. You will need a return of more than 10% a year to reach this goal.

In order to earn such a return, you will have to look to an investment with a higher level of risk than simply investing in cash (a bank account or money market fund) where returns are typically only one or two percentage points higher than inflation.

The return you need will help you identify the asset class or mix of asset classes most likely to deliver that return.

If you decide you need to earn, for example, inflation plus 6% (the inflation rate plus six percentage points), to reach your goal within your investment term, this will require a high exposure to asset classes that can deliver high returns above inflation, such as equities.

Investing in such an asset class does, however, come with volatility.

For this reason, the asset classes and multi-asset funds that include them have recommended investment terms – if you stay invested for the full term, your investment is likely to deliver, on average, the return you need.

For example, the recommended term for investment that aims to deliver an average annual return of inflation plus 6% may be five years or more.

The recommended investment term and the average annual returns for that period should be based on an analysis of long-term returns for the investment, those investing in the same instruments or investment universe. 

If the recommended investment term is five years, this should be based on the average annual return of not only the past five years, but also the return over every five year period for a long period, such as 20 or 50 years.

If the period over which you plan to invest does not match the recommended term, for example, if you need to withdraw after three years instead of five, you may still have earned a good return, or it may be that you will withdraw after the worst three years within the five year period. Withdrawing before the recommended term, increases your risk of investment loss.  Read more: What do I need to know about investment risk and time?

If you need to invest for a shorter period, you will have to adjust your return expectations accordingly. This means you will need to increase the amount you save or reduce your goal amount.

Realised and paper losses

In addition to the average annual returns over the recommended term, you should also consider the highest and lowest returns your investment may achieve in any year.

Then you need to distinguish between investment losses that are realised and those that are not. If you invest in, for example, shares on a listed market, you expect a good return above inflation over a recommended term.  You know, however, that it comes with volatility, or returns that may be up or down, over the short term.

You should understand that while your investment may lose money at some point, unless you sell the investment, you have not realised the loss. Your loss is said to be on paper only – you saw it on your statement, but you have not realised the loss because you have not sold the investment.

If you hold the investment for longer, it may regain its loss, especially as periods of poor returns on financial markets are often followed by periods of high returns.

Knowing this information will help you decide if you can afford to take a particular level of risk over the relevant investment term - and if you are comfortable taking this risk. With this information, you can be prepared for paper losses, you will know that you can sit them out in order to achieve good longer-term rewards.

Comfortable levels of risk

The level of risk you are comfortable with is the one you can both afford to take and can tolerate.

Your capacity to take risk, or afford it, and your ability to stay cool in the face of market decline, or your risk tolerance, should also be tested as part of your risk profile. Read more: What is my risk profile and why does it matter?

SPECULATION VERSUS INVESTMENT RISK When you invest in something risky and have no idea how it will pan out, you are speculating. Investment risk is more calculated. The long-term returns financial markets have delivered are well-researched. There is always an element of uncertainty and there can be long periods when markets perform better or worse than their long-term averages. You do, however, have a reasonable amount of certainty that investing in shares and investing in cash - a bank account or money market account - have different risks and rewards. You can be reasonably sure you will earn more in the share market than in a bank account, if you can stay invested for three to five years. In the share market, you must endure investment ups and downs while in a bank account you have a higher level of certainty that your savings are stable.