How To Think About Risk When Investing

Whenever I hold a personal finance planning session and we get to discussing investment strategies, the issue of personality type always comes up. People will say they’re not risk takers, and therefore they prefer investments that are not risky. Others will say that they are risk takers and prefer investments that have high returns and involve a bit of adventure. I must admit I do not get too many risk-taking clients, as they tend to also be averse to personal finance advice – the basics can sound boring and unadventurous.

Personality becomes an area of discussion because people would prefer investments that suit their personality types and attitude towards risk. The expectation is that I will recommend investments that do not feel too scary or risky if they are risk-averse, and the converse if they are risk-takers.

But that’s not how investing works. First, investment decisions are not about personality type but about the nature of the investments themselves. If you want to be a successful investor, you need to divorce your “self” and your emotion from the investing process.

“I will tell you the secret to getting rich on Wall Street. You try to be greedy when others are fearful. And you try to be fearful when others are greedy” – Warren Buffet

Warren Buffet, one of the most successful investors of all time recommends achieving level of self-masterly where your attitude towards the market is based on how the market is behaving, and not how you feel (you might feel just as fearful as everyone else, but your actions should be greedy, and vice versa, where you retain a level head when everyone else is going crazy).

Does this mean risk does not matter?

No. When we talk about high-risk and low-risk investments, we are talking about how much their returns fluctuate in the short term. Risky investments fluctuate more in the short term and therefore pay less in returns and could even give negative returns in the short term. But they also pay out more in the long term (think 7-10 years).  Low-risk investments do not fluctuate as much. They will pay out more or less the same returns both in the short and in the long term, and overall tend to pay out less money.

The second thing that may speak to risk is how quickly you would be able to convert your investment to cash, should you need it quickly. Finance people call this liquidity. Low-risk investments tend to be pretty liquid. Either they are cash or near cash, or can be converted into cash very quickly. For example, a money market investment may not be cash, but my money market fund manager only needs a 5-day notice to convert it into cash. One will then ask, are stocks (shares) low risk because they can be converted into cash rather easily? Well, yes and no. Shares that are listed in the stock market are liquid because if you need your cash back, you just request your stock broker to sell them. They are however not low-risk because of the fluctuations we have talked about above – depending on the market movements, share prices fluctuate in the short term. As such, you may not realize a profit should you need to urgently sell your shares and the market happens to be down.

Keep in mind though, that this is a discussion about real investments. Not speculative adventures, or sport betting. I like how Sam Beck Bessinger discusses investments in her book, “Manage Your Money Like A F*cking Grownup”:

Underneath all this finance vodoo you hear about – stocks, bonds, endowments, the financial economy – there is a real economy. Finance people don’t really make money grow using magic fairy dust…Your money grows when companies in the real world use that money in their businesses. The best way to grow your money is when you understand how it’s growing. If it feels like it’s all smoke and mirrors, it might just be. 

How then should we think about risk?

Assessing whether you should invest in a high-risk investment or a low-risk investment shouldn’t have anything to do with your personality. The only question you should consider when deciding the right amount of risk to take on is how long you are investing for. If you are going to need the money soon, then you want to go for the low-risk investments that do not fluctuate as much. However, if you can afford to wait, you should go for the higher-risk investments.

How do you know how long you can wait? By having a financial plan in place. A plan tells you what proportion of the money you save is for your long-term goals, and what’s for the short-term. That way, it guides your investment decisions, as opposed to going with the gut, or just investing in what everyone is investing in.

Finally, I want to share what I told a friend who asked me about a low-risk investment that would give her high returns in a 2-year period. Investing is a long game, especially if you are young and you have time on your side. Take advantage of the time you have by going for a mix of investments. Consistently invest at least 70% of your long-term money in good stocks, and forget about them and let your money grow.