Even if you're just starting to research different investments, you've probably already heard the term 'risk' thrown around. "Make sure you're comfortable with the risks of investing." "When investing your capital is at risk." "The higher the risk, the higher the expected return." It's one of the main terms that investing content, trading platforms and apps will explain when it comes to putting your money in anything other than cash in the bank.
The problem is, they're doing it all wrong.
As an industry, we do a terrible job of using the word risk, when really what we actually mean is volatility.
It's a problem, because it makes it seem as if investing is like swimming with sharks or base jumping off a cliff. But this is why savvy and experienced investors don't panic when the stock market tanks. We understand the difference between risk and volatility, and why (if you're doing a proper job of investing), you don't need to worry about either of them.
Right, let's start with properly defining the term risk. What does it actually mean? Risk is the potential for you to invest in something that permanently loses you money. The word permanently is absolutely crucial here.
Consider a fairly recent example from the UK, Debenhams. If you had invested £1,000 in Debenhams shares, you were accepting the risk that they could go out of business, and you'd lose your money. Unfortunately, that's exactly what happened. Debenhams was wound down in late 2020, and investors would have lost all or most of their investment.
Risk applies to any single investment you can make, whether that's a cryptocurrency, a fixed interest investment like a bond or a gilt, or more niche investments like startups on Seedrs or P2P lending.
So we've defined risk, but how is volatility different? Volatility is the potential for there to be fluctuations in the value of your investment, causing you to lose money temporarily. Like risk, there is an important word here. Temporarily.
Almost every investment will fluctuate to some degree. The more risk involved with a specific investment, the more volatility it's likely to experience. With Debenhams struggling to generate profits for years, you would have expected the volatility to be much higher than for a company like HSBC or Apple. This is because the risk of Debenhams going under was significantly higher.
This range of volatility isn't just limited to the stock market. Bonds with different risk levels will have different levels of volatility, as will cryptocurrency, precious metals, and even property.
It's important to remember though, that the trade-off for higher risk and higher volatility is the potential for higher returns. With their share price in the basement, investors would have been able to pick up Debenhams stock at rock bottom prices. If the company had managed to turn it around, the investors would have been looking at very healthy profits. With other companies that are considered more secure and are performing well, investors need to pay more to get into the game, which means there's less potential for big returns.
Here's why everyone is getting it wrong when they talk about risk and volatility. The terms are used interchangeably, but they're not the same thing. True risk can be effectively eliminated completely, if you invest in the right way. Volatility can't be, it's just part of the game when it comes to investing, but it can be easily managed as well.
When investment managers, apps or Financial Planners ask you how much risk you're prepared to take, what they are really asking is how much volatility you're willing and able to accept. Will you be able to sleep at night if your portfolio drops by 20% in a short space of time? Are you likely to need the money in 12 months' time when markets could be down?
The good news is that if you structure your investments in the right way, you don't really need to worry about either of them. Let's break down exactly what you need to do.
To eliminate risk from your portfolio, all you need to do is diversify. If you invest in Debenhams and Apple and HSBC, your portfolio has a lot of risk. Those 3 companies could go bankrupt, and you could lose a chunk of cash. Instead, if you invest, for example, into the S&P 500 (the 500 biggest public companies in the US) and the FTSE 100 (the 100 biggest public companies in the UK), you effectively eliminate that risk.
The chances of all 600 of these companies going bankrupt at the same time is basically nil. It would mean there are no longer any supermarkets, banks, accounting firms, fuel companies, tech companies or power providers. If this was to happen, we're more likely to be worried about keeping the zombies at bay than what our investment portfolio is doing.
Managing volatility is pretty simple too. Diversification helps a lot here, and you can bring in defensive assets like bonds and other cash-based investments to bring it down if you need to. But the greatest way to manage volatility is through time. If you zoom out far enough on a stock market chart, even big crashes like the dot.com bubble and the 2008 financial crisis just look like blips on the radar.
Most of the time we say a timeframe of 5 years is about the minimum you want to have when you're starting to invest. If you're putting money into the market, you should plan not to take it back before that time is up, because it gives time to ride out the ups and downs.