Back in lesson one, we looked at the main reason why we invest our money – which is to retain its spending power.
By keeping our money in a cash savings account and retaining the interest it generates over time, we can hope to at least keep up with inflation.
Hurrah! We’re not getting any poorer.
But we’re also not getting richer:
- We’re only keeping track with inflation…
- …and to do so, we can’t spend much – if any – of the interest earned.
Super-investors like Warren Buffett didn’t become multi-billionaires by saving into cash accounts.
In fact, it’s very hard to even retire comfortably if all we do is match inflation with our savings.
Please sir, can I have some more?
You need a savings pot of roughly £500,000 to generate an income of around £20,000 a year.
Let’s imagine you’re 40. You want to retire at 65, and you already have £100,000.
You can quickly calculate you might need to save at least £10,000 every year into your cash account to reach your £500,000 target1 in today’s money.
(Your pot by 65 in this example would be around £700,000. But remember: inflation will have eroded its spending power. So we’re assuming that £700,000 will only buy what £500,000 gets you today.)
Finding £10,000 a year in cash to save is very hard for most people. (It’s easier when using a pension, especially if your employer contributes.)
Ideally we want our money to work much harder to generate more of what we’ll need to enjoy a comfortable retirement.
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.
Examples: Corporate and government bonds, shares (equities), property, and gold.
The bad news is all of these options introduce new risks that we must take in order to have a shot at the potentially higher rewards they offer.
Cash is the only completely 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.
Risk and return 101
Like a lot of investing, talk of risk and reward (i.e. the return you make on your money) can sound off-putting
But actually you’ll already understand the basics.
That’s because there are lots of different kinds of risk/return situations in everyday life:
- The lottery – astronomical one-off odds that you’ll win (/return) a lot of money.
- Learning to drive – the chance of an accident falls over time, but never to zero.
- Tossing a coin – 50/50 chance each time. Over many tosses it averages out.
- Russian roulette – ‘only’ a 1/6 chance of death at first. Rises to 6/6 eventually.2
Investing risk similarly comes in different shapes and sizes.
Risk and return three ways
Remember the smooth graph of returns from cash we saw in lesson one?
Let’s call it Graph A:

Every year we have more money than before. That’s ideal, surely?
Well, compare it to the value of our investment over time in Graph B below – and pay attention to the ‘Y’-axis:

Graph B shows a much riskier investment. Risk here is synonymous with volatility – the value of this investment goes up (yay!) but also down (boo!)
You can see we even fell below our initial starting point for a while, before eventually coming good.
We endured this volatility for higher returns.
Things would have been very different if we’d cashed out early in year seven. We’d be down 40% on our starting capital.
That’s important: even when you invest for the long term, taking risks isn’t guaranteed to pay.
Introducing Graph C:

This time things started well, but in year 13 disaster struck. We lost the lot!
(How? Perhaps we invested in a failed company like WeWork or Northern Rock, or a buy-to-let apartment that burned down without insurance.)
Risk versus reward
These various graphs reveal two key risks 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.
Which of the following three investments do you prefer?
- Investment One goes up like Graph A for a final value of 150
- Investment Two goes up and down like Graph B for a final value of 150
- Investment Three bounces around even more than Graph B, before ending at 200
The sensible answer is to prefer Investment One to Investment Two. Why put up with sleepless nights from volatility for no extra reward in the end?
Investment Three might be worth it, provided you can take the volatility. But what if there’s a 10% chance of Graph C – a total wipeout?
And there’s the final snag. 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 this interplay of risk and reward.
If something looks too good to be true, then you are probably not seeing all the risks.
Key takeaways
- All investments have different risk and reward profiles
- 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 chance of a permanent capital loss.
We’ll see as we go through this series that the best way to manage 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 all our articles by email and you’ll never miss a lesson! Why not tell a friend?
As a sage once remarked, people have no objection to upwards volatility, it’s downwards volatility they dislike.
“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!
@Dave — Indeed! Actually bamboo is the new thing, going by my email spam filters.
@The Investor — Don’t invest in bamboo, you’ll get caned.
🙂
@Ric — Stop panda-ring to the crowd. 😉
@Ric @The Investor – These comments have me bamboozled. (I’m as ashamed as I should be about this comment) 😉
These jokes are becoming un-BEAR-able.
Would you say volatility risk is a non-issue if you have a long time horizon?
@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. 🙂
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!
@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!
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.
Following on from the above, (a bit late), ‘whats the most freightening thing in the jungle?
BamBOO
“You need a savings pot of roughly £500,000 to generate an income of around £20,000 a year”.
It’s very possible to get a higher income than this 4% return, not by doing anything freaky and going for over-speculative investments but by choosing higher yielding, say, investment trusts. You just need to do some research and find the right ones for you. Even pushing this to a yield of 6% would give you £30000, which might appear more comfortable to many than £20,000.
@Mike Johnson — Of course it’s possible to get a higher return than 4%, by taking on more risk. There is a spectrum between ‘safe’ and ‘freaky and going for over-speculative investments’ and at each step along, you’ll take more risk for a (hopefully) higher return.
Generally the greater risk will be more volatility in the value of your investment day-to-day. So long as they have the appropriately long time horizon and there’s good reason to expect higher returns, most people should indeed be happy to take on some of this higher risk for higher returns.
But this article is about understanding these risk/reward essentials, not advocating for whether 4% or 6% is a good return. 🙂
I reckon the most important financial decisions are to do with marriage and children !
As for the difficulty of saving £10000 a year (after tax), yup, so why is the ISA limit £20000 and the maximum annual pension contribution £60000. The rich have all the fun.
@Mike Johnson
I have a soft spot for high yield investments – preference shares and more recently L&G which yield nearly 10%.
But it’s artificial in some ways – look at the L&G share price before and after it went ex dividend. The share price dropped by 15p, which “coincidentally” was the amount of the dividend.
It’s not a free lunch
@Boltt
Definitely not a free lunch. My aim in decumulation is to broadly maintain, not spectacularly increase, the overall value of my investments while taking a level of income that’s comfortable. Three years on, it’s doing ok. I suppose I was just trying to point out to anyone at the other end of the investment timeline who might be intimidated by having to save £500k to get £20k a year, it just might be possible to get a little bit more.
@The Investor
“Generally the greater risk will be more volatility in the value of your investment day-to-day.”
Perhaps. But what can confidently be said to be low volatility in this day and age anyway? I remember devouring wisdom in these pages a few years ago about bonds acting as your investment parachute – easing your fall to earth when markets were rough. But that was not really how it worked out, was it? One thing I have learned is that there aren’t many absolute truths in investing.
But what does “risk” and “speculative” mean *exactly*? Like “passive” and “active”, they get bandied about all the time but too often without appropriate context or concrete definition.
Is risk volatility? Or is it the permanent loss of capital? If it is volatility, then over what period of time, and compared to what alternative?
And why precisely is volatility “risk”? In some context it is a risk, but in others not.
If you need to sell when the market is down, then volatility is a risk.
If you’re DCAing and doubling down on the regular amount on an X%age drawdown from the 12 month high, then volatility is an opportunity, not a risk.
Is the consensus “low risk” and the fringe “high risk”? It all depends.
The consensus on equities in 1999, 2007 and 2021 turned out to be high risk. Likewise with bonds in 2020.
In contrast, the fringe view in relation to tech in 2002-3, 2009-13 and in 2022 turned out to be low risk.
Same for the sovereign debt of the PIGS during the Eurozone crisis. Yes, it could have turned out differently, but it didn’t.
And at 13 Euro cents and 26% YTM Greek debt in 2012 was supposedly high risk, but the (then seen in 2012 as being ‘safe as houses’) UK long duration linker tracker ETF INXG now trades at the same price (£11) as it did way back in 2010, having drawn down over 50% since November 2021. They couldn’t get enough of it then. Now they won’t touch it at half the price.
The ‘wisdom’ of the crowd. The market is always right – ROFLMAO to that.
And why is it ‘safe’ to buy an incumbent with a ‘moat’ that consists only of its own brand in a discretionary market subject to changing tastes (e.g. Diageo), but not a ‘disruptor’ creating a new market for itself (e.g. Palantir with Gotham and AIP) or a company with 100% ‘toll booth’ like monopoly in a globally critical process/good (e.g. ASML with EUV lithography)?
Safe and risky mean nothing in and of themselves. What’s safe in one context, and over one timeframe, is dam risky in another.