I was asked a great question recently. For all the talk of KiwiSaver-this and investments-that, what does it actually mean for my dollar? How much do I put in and for what return? Here we come to the wonderful world of ‘Risk’. What is ‘risk’ and what do insurance and investment companies mean by it?
KEY POINTS:
- What is risk
- What is the ‘return’ part of “risk and return?”
- What is my comfort level?
What is risk?
Risk is a level of uncertainty that something will or won’t happen. There is a relatively large risk that you might get hit by a bus if you cycle everywhere around the city. There is a very small risk that the sun won’t rise tomorrow in the East. Both might happen, one is more probable than the other.
Probability is chance; what is the chance of something occurring. Toss a coin five times and you might come up with heads a few times and tails some other times. You have a 1/32 (or 3.125%) chance you will get all heads in 5 attempts.
Risk then, in our context, is about probabilities and uncertainty around money. This is also known as interest. When you see an interest rate, which is a percentage, they are talking about the risk related to that money. Specifically, the risk associated with that money over time.
What is the ‘return’ part of risk and return?
What does this have to do with finance, investments and savings? The percentage rate is the risk associated with how the capital is used. When you are looking at asset classes, these will have different returns. What is a return? It is the money you are likely to get back from the investment.
Again, to over-simplify things, your money in a bank is considered to be very safe. When you need it, you can withdraw it, easy-peasy (term deposits notwithstanding: these require notice before you can withdraw). Because there is very little risk to your money not being there when you want it, the bank will only pay a very small amount of interest. Current account rates are barely above zero right now (2020). Even term deposit rates are only 1.5%.
Other asset classes will have higher expected returns. For example, the historic averages for some asset classes are shown below. These are annualised returns from 31st December 1970-31st December 2018*.
- New Zealand Equities – 12.2%
- Australian Equities – 10.7%
- World Equities – 10.7%
- Residential property (capital gains only) – 8.8%
- New Zealand Bonds – 7.8%
*data from Booster.co.nz
As an example, you have $1,000 to invest. If you put that money into a standard savings bank account at 0.5% interest, then your return would be $5 in a year. If you invested that same $1,000 in NZ shares at 12.2%, then your return would be $122.
Shares are deemed to be riskier, or to have a greater risk that you will lose money, therefore the expected return is higher, to compensate you for taking a bigger risk.
What is my comfort level?
The media like to throw around percentages and numbers, and it can become meaningless for people very quickly. What is a 5% gain and what does that even mean to me? Is that 5% in a day, a month or a year?
It is very easy to get overwhelmed by the media and our own expectations. So bring it back to where it is relevant to you. Four simple questions to start:
- What are you trying to achieve?
- What is the purpose of you investing your hard-earned cash?
- What time do you have?
- Are you prepared to take the loss if things go wrong?
For example, are you saving for a post-COVID trip to a pacific island? Or are you investing to give you an income in your seventies? Two very different things to aim for. Both require thinking about your risks differently.
If someone is going to offer you a 50% return on an investment, then it seems as though there is a lot of risk involved in that. Remember tossing that coin? You have a 50% chance of turning a Heads. You also have a 50% chance of losing. Are you prepared to lose? There is a big difference between long-term investing and speculation. Speculation is on the same continuum as gambling. If that is what you want to do, fine, just know that you are gambling and not investing.
Before taking any investment, think through what you are trying to achieve. Talk through your ideas with qualified and professional people. Jump on to www.sorted.org.nz to see what a 5% return actually looks like for your cash investment. Read some articles. Be informed. The returns are worth it.