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.
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:
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:
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:
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.
- The safest investment (or asset) is cash.
- All investments have different risk and reward profiles.
- 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.
- Tip: If number five escapes unscathed, stop playing! [↩]