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Investing for beginners: Risk versus reward

Investing lessons are in session

Back in lesson one, we looked at the first and foremost reason why we invest our money, which is to retain its spending power.

By keeping money in a cash deposit account and saving up the interest it generates over time, we can hope to at least keep pace with inflation.

Hurrah! We’re not getting any poorer!

But we’re also not getting richer.

  • We’re only keeping track with inflation.
  • To do so, we usually can’t spend much if any of the interest.

Super-investors like Warren Buffett didn’t become multi-billionaires by saving into cash accounts.

In fact, it’s very hard to retire comfortably if all you do is match inflation.

In today’s money, you might need a savings pot of roughly £500,000 to generate an income of around £20,000 a year.

Imagine you’re 40, you want to retire at 65, and you already have £100,000.

I calculate you’d probably need to save £13,000 every single year into your cash account to reach your £500,000 target. (Remember, all in today’s money).

That’s impossible for most people. We need our money to work harder.

Desperately seeking a better return than cash

The good news is there are plenty of other places we can put our money to work besides cash deposit accounts.

Examples: Fixed cash ‘bonds’, government bonds, shares, property, and gold.

The bad news is that all of these introduce new risks that we must take in order to have a shot at the potentially higher rewards they offer.

Cash is the only safe investment – and even it faces risks like bank crashes, or the risk that the interest we’re paid is inadequate to keep up with inflation.

You’ll already be familiar with different types of risk from real-life:

  • The lottery: Astronomical one-off odds that you’ll win a lot of money.
  • Learning to drive: Chance of an accident falls over time, but never to zero.
  • Tossing a coin: 50/50 each time. Over many tosses it averages out.
  • Russian roulette: 1/6 chance of death at first. Rises to 6/6 eventually.1

Similarly, investing risk comes in different shapes and sizes.

Remember the smooth graph of returns from cash we saw in lesson one? Let’s call it Graph A:

2.cash-return-time

Every year we have more money than before. Who wouldn’t want that?

Compare it to the value of our investment over time in Graph B:

2.volatile.return

Here the value of our investment went below our initial starting point before coming good. We’ve endured volatility for higher returns.

It would have been different if we’d cashed out in year 7. We’d be down 40%!

Even if you plan to invest for the long term, taking risks isn’t guaranteed to pay.

Introducing Graph C:

2.investment-goes-to-zero

This time things started well, but in year 13 disaster struck. We lost the lot!

These graphs show two key types of risk when investing:

  • Volatility – The risk of your investments going up and down in value.
  • Capital loss – The risk of permanently losing some or all your investment.

Risk versus reward

Which of the following three investments do you prefer?

  • Investment 1 goes up like Graph A for a final value of 150
  • Investment 2 goes up and down like Graph B for a final value of 150
  • Investment 3 bounces around even more than Graph B, before ending at 200

The sensible answer is to prefer Investment 1 to Investment 2. Why put up with the sleepless nights from volatility for no extra reward?

Investment 3 might be worth making, provided you can take the volatility. But what if there’s a 10% chance of Graph C?

What if, indeed… The final snag is we don’t know what the graphs will look like in advance.

Hence we can never be sure how our returns will play out until the end.

Almost all investing decisions boil down to the interplay of risk and reward. If something looks too good to be true, it is probably because you are not seeing the risks.

Key takeaways

  • The safest investment (or asset) is cash.
  • There’s no point taking extra risk if you don’t expect a higher reward.
  • Risk can mean volatility.
  • But risk can also mean the risk of permanent capital loss.

We’ll see as we go through the series that the best approach to tackling these risks is to diversify your money across different kinds of assets, to reflect your personal attitude towards risk and investment.

This is one of an occasional series on investing for beginners. Subscribe to get our articles emailed to you and you’ll never miss a lesson! And why not tell a friend to help them get started?

  1. Tip: If number five escapes unscathed, stop playing! []

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{ 13 comments… add one }
  • 1 dearieme July 25, 2013, 10:23 pm

    As a sage once remarked, people have no objection to upwards volatility, it’s downwards volatility they dislike.

  • 2 Dave July 26, 2013, 10:26 am

    “Almost all investing decisions boil down to the interplay of risk and reward. If something looks too good to be true, it is probably because you are not seeing the risks.”

    I think all wannabe ostrich farm investors and fine wine investors ought to consider this!

  • 3 The Investor July 26, 2013, 11:39 am

    @Dave — Indeed! Actually bamboo is the new thing, going by my email spam filters.

  • 4 Ric July 26, 2013, 3:34 pm

    @The Investor — Don’t invest in bamboo, you’ll get caned.
    🙂

  • 5 The Investor July 26, 2013, 4:29 pm

    @Ric — Stop panda-ring to the crowd. 😉

  • 6 The Shoestring Investor July 26, 2013, 6:44 pm

    @Ric @The Investor – These comments have me bamboozled. (I’m as ashamed as I should be about this comment) 😉

  • 7 Jon July 26, 2013, 11:12 pm

    These jokes are becoming un-BEAR-able.

  • 8 Anonymous July 27, 2013, 9:23 pm

    Would you say volatility risk is a non-issue if you have a long time horizon?

  • 9 The Investor July 27, 2013, 11:09 pm

    @Anonymous — I’d say it becomes less of a risk, yes, but not a non-issue. There are psychological consequences to seeing your wealth rise and fall, even if you believe (perhaps rightly) that you will hold for the long-term. So it’s never a non-issue in that very real emotional/behavioural sense. Also, the spikes and troughs can last a lot longer than most of our timeframes in the worst case scenario — the classic example is Japan, where the market was nearly 40,000 in 1989 and is still less than 15,000 today, nearly 25 years later. Finally your time horizon (assuming you are a private investor, not an institution) is always shrinking, for obvious reasons!

    None of this is a reason to shun volatile assets in most cases, but I’d never say “non-issue”, personally. 🙂

  • 10 Moses August 13, 2013, 9:18 am

    Thanks for the beginner series. Very helpful. Will you be covering any aspect of value investing and how a newbie investor can get started? I already max my annual ISA, invest in vanguard index and have a comfortable peace of mind account.

    Now, I’m interested in investing a portion of my savings into stocks but applying the principles of value investing.

    Your site has been very helpful. Thanks!

  • 11 The Investor August 13, 2013, 10:06 pm

    @Moses — I’m glad you’re enjoying the articles and the site — thanks for letting us know. Always good to hear!

    Regarding a beginner’s guide to value investing, it isn’t very likely to be honest. I have done the odd value investing teaser (search for “Value Investor” or “value investing” in the search box in the sidebar as a first start perhaps) but beyond that I think you need to go deep with individual share investing, or you shouldn’t start at all. (Well of course going on results, which will on average at least lag trackers, most people should never start at all whatever they do, but that’s another issue!)

    This series actually is partly inspired by some conversations I had with a friend who wanted to learn how to stock pick, and I suggested she needed to learn the basics of risk and reward first. My aim was by the end of it to get her to see that trackers were the best solution for her, and I failed, but the experience only made me doubly sure most people should not be trying to pick stocks.

    If you do want to take the next step to add value you might consider doing it through a passive value ETF or similar?

    Don’t get me wrong — each to their own, and I run plenty of my money actively for myself. I love stockpicking, and it’s one of my main passions in life these days, all in. But it’s a big risk.

    If I do ever go deep on value investing or similar, it’s likely to be either on a different blog or book, or perhaps in some sort of subscription / member’s only area I think.

    Good luck with your investing!

  • 12 Moses August 14, 2013, 10:45 am

    Thanks for the followup – I already invest in Vanguard S&P 500 ETF Shares, the Vanguard Life Strategy Index Fund (80%) and cash ISA. In terms of passive investing, I think I’ve got a good balance.

    If you do start a member’s only channel for value investing, I’d be very interested. Enjoy your style of writing and easy to grasp.

    Thanks for your help.

  • 13 richard November 10, 2013, 6:23 pm

    Following on from the above, (a bit late), ‘whats the most freightening thing in the jungle?
    BamBOO

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