Are you Taking Enough Risks?
Three Ways to Reduce the Risk you Take with your Money
A ship is safe in the harbour but that’s not what it was designed for
John A Shedd (1928)
Imagine owning a sailing ship in the 17th Century. The aim of the game was to move cargo from A to B getting the most profits whilst taking the least risk. You wanted the biggest amount of income from the ship with it bothering your day to day life as little as possible.
It’s very similar to investing today. Every pound coin you invest it like a small ship working for you, every minute of every day. The more risk you are willing to take the greater your reward over the long term. Risk is paid for taking chances.
Every pound coin you invest it like a small ship working for you, every minute of every day.
It would be doing business with an unknown market or going a little further afield than was previously thought possible. Now imagine stepping foot on board your cargo vessel.
You feel the wind on your cheek as you look out to sea, your footing is a little uneasy as the deck rolls up and down with the waves of the sea. There are many risks to consider and like any human you want to maximise your returns, whilst taking as little risk as possible.
Why should we invest?
There’s always the option to leave your ship in the harbour, to choose not to harm your ship against the elements of nature, of meeting pirates along the way or to take the chance of getting lost and not making it to a safe port without losing your supplies.
This seems an easy option but being in harbour is not what your ship was designed for. If your ship didn’t make the perilous voyage then there would be no tea for your morning cuppa, no wine to drink with friends or no clothes to wear to work that day. Investing like Shipping is a balance between risk and reward.
Taking no action can seem like the easy option. Not investing and keeping your money safe in the bank this is not what money was designed for. Taking risks is part of life. If we stop taking any risks then trade would stop and the economy would grind to a holt. We would not be able to exchange our good and services to someone else who wants or needs this and both parties would be better to exchange their specialist knowledge and benefit from their individual strengths making it a win/win/win.
What is Risk?
Risk is a slippery and elusive concept which is little understood especially with investing however the dictionary definition of risk is ‘the situation involving exposure to danger or harm’. In investing the aim to get the most rewards with taking the correct level of risk for their situation. Every day we encounter risk. Just going to work we are taking some kind of risk, the world is an unpredictable and unknown environment which can never be risk-free. Even if you never leave the safety of the harbour walls you are missing opportunities that you may have received by applying for that job, asking the girl you want to date or putting your money into the stock market. Risk is an unavoidable part of the investment process.
Every day we encounter risk. Just going to work is taking some kind of risk, the world is an unpredictable and unknown environment, which can never be risk-free
Although there are many different types of risks when investing, the two main types that will affect your portfolio are market risk (volatility) and inflation (the erosion of the pound in your pocket).
The main risk you will face is volatility, which are the ups and downs of the market. Volatility is what most people fear. It makes the headlines news when the markets take a tumble and causes fear in losing their money they have invested. Think of these ups and downs of volatility like the waves in the ocean. The more risk you take the bigger the waves. If you are closer to shore in a sheltered bay, then the waves will be less and will be taken on less risk as historically a boat anchored in that bay will less likely to sink or capsize by the waves in this less risky area. The further out into the deep ocean you sail the bigger the wave and the greater the risk, however with this greater risk comes greater reward.
Think of these ups and downs of volatility like the waves in the ocean. The more risk you take the bigger the waves.
Risk is measured by the volatility of returns called standard deviation. This measures how wildly the investment moves up and down. The greater the standard deviation, the greater the volatility and therefore the associated risk An investment with returns fluctuating wildly (think about cryptocurrencies in 2015–2018).
Investments with returns staying close to its expected returns is said to be low risk and therefore low standard deviation.
Inflation risk is rising prices that reduce the real value of your money. It’s the rising prices of everyday goods that you buy in your weekly shop. Inflation is the silent killer. You often don’t notice it’s there until one day when you buy your weekly shop you realise how much more you are paying for goods.
Think of inflation as the wind against your cheek. Often you don’t take any notice of the breeze but over time there is a huge difference on how far you get between sailing with the wind in your face or blowing at your back. Think of the price of London houses. The property asset has risen astronomically over 30 years if you choose to keep your money in cash rather than buy a London property in the 1990s that pound in your pocket would be worth much less today. Inflation is measured in the UK using the retail price index (RPI).
It takes several everyday items from your shopping basket that are bought by everyday people and measures them monthly to see how much prices have risen or fallen (a falling price is called deflation).
Think of the market like a stream of water that is in constant motion. It does not start, stop or wait even when the market is closed it’s still in motion. Since the markets are in constant motion this money has energy and is constantly flowing, which makes the possibilities for success greater magnified and seemingly within your grasp.
Think of inflation as the wind against your cheek. you may not notice the breeze but over time there is a huge difference on how far you get between sailing with the wind in your face or blowing at your back.
The best investors think differently from the rest. Learning to identify an opportunity to buy or sell does not mean that you have learnt to think like an investor. An investor is someone who gets both a return and their original money back. The aim is to get the desired reward by taking the least amount of risk available. In investing the aim to get the most rewards with taking the correct level of risk for their situation. In investing people want to be risk-free so they don’t lose their hard-earned money. Keeping money in a bank for many people seems to be a way to be risk-free however this is not true.
The hard route often turns easy and the easy route can turn hard.
How to reduce your risk?
Sailing a ship in the 17 century faced many dangers, risk treacherous sea, bad weather, piracy even mutiny. These hazards mean that a merchant’s fortune could literary disappear overnight. Like investing today there were three ways to reduce the risk you took.
The best investors think differently from the rest. Learning to identify an opportunity to buy or sell does not mean that you have learnt to think like an investor.
The three ways to reduce your risk is to use insurance, have more reserves or to diversify your cargo. Reducing your risk means that you are more likely to make a profit, it will also give you peace of mind that you will not lose all your precious cargo and your life’s savings overnight. This will give you a better night’s sleep.
1)The first way to reduce your risk is through diversification. Having different asset classes in your portfolio (like shares of a business, bonds, property, commodities and cash) and also diversifying within that asset. By having different shares of businesses that provide different types of goods and services that business will perform better or worse in different environments.
Investors can reduce the risk of their portfolio by holding a range of different types of assets. Different types of investment perform differently in certain market conditions and by having a diverse range of asset classes the fluctuations caused by most economical events can be smoothed rather having one asset class which increases the volatility and therefore the risk.
The downside of one asset class will be counterbalanced by the upside potential of another investment. This offsetting would not occur if both investments had the same characteristic. Diversification is effective where individual assets move in different directions.
2) The second way to reduce your risk is through insurance. to pool your ships with other ship owners. So rather than putting all your cargoes in one ship ( or all your eggs in one basket to use the common phrase) You split the risk between not just one ship but hundreds of ships.
If one ship sank all owners would suffer a small loss however this would be much better than risking it all on one ship. This is a form of insurance that was started in Lloyds of London coffee shop in 1680. Today you can insure yourself for any loss to yourself by insuring yourself
3) A third was to reduce risk is to have enough reserves to cover any fluctuations. By reserves, this means cash or bonds that tend to do well in falling markets. It could be possible to invest your reserves when the market is down to take advantage of the lower prices.
The amount of risk you should take all boils down to how well you want to eat versus how well you want to sleep.
Neil Doig is the Director of Money Tipps a money coaching company. Money Tipps educate and inspire better investing without paying expensive fees.
His book Millennial Money Mindset: If you want the Fruits you Need the Roots was shortlisted by the Financial Times and now available on Amazon.
Neil Doig is also the creator of Football Formation Asset Allocation. How to invest your ISA, which is a learning experience.
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