Keys To Successful Investing - Understand That Risk Equals Return

Keys To Successful Investing - Understand That Risk Equals Return

Be aware of risk. Ask questions and understand the true nature of risk in any investment before you do anything.

Etch the words "risk equals return" into your bathroom mirror so you can see them every morning. Taking excessive risk in looking for a big return is the number one reason why investors lose their money. They get too greedy - and investment salespeople know this.

The only way you can circumvent the classic relationship between risk and return is to obtain information that is not widely known. With shares it is called "insider trading", and the penalties are high if you get caught. With property, inside knowledge about things like rezoning can be very valuable but, unfortunately, over the years a number of people have abused their position of trust on such matters. For most of us, inside knowledge isn't available and we must invest on the premise that the return we get will be related to the risk we take.

If you see an investment offering a high return, don't say "oh good', but ask "Why?". Examples such as Estate Mortgage and Pyramid Building Society spring to mind. To attract money they offered higher rates of interest than their competitors. To pay this higher rate they lent the money on more risky projects. The result? Investors lost most of their money when it all collapsed. Now, I'm not saying risk is to be avoided. If you take no risk, you get no return. Everything has some risk, but you must be aware of risk. The real trick is to consider how much risk you can sleep with, and to invest accordingly.

To illustrate this, let me describe my family's investment strategy.

For my young kids, I put around $500 a year into an international managed share fund with a strong focus on emerging markets such as in Asia. Sure, this is risky and Asian markets took a hiding in the strategy will give my kids the highest return over the decades. Look, if the kids make 60% one year and lose 60% the next, it doesn't matter - they don't even know about it! At their age, investment risk is irrelevant to them.

At my age (36), I would not invest all my money in emerging markets shares because of the high risk. However, I have been more than willing to invest some of my super money in this area - because I won't be touching it for many years.

Having paid off my mortgage, my main plan at this stage is to build up my super and a portfolio of other investments, such as American shares and perhaps even some investment property.

As I age, my attitude to risk will change. I'll be more concerned with protecting my wealth, no growing it, so I will gradually switch to lower risk investments such as cash, fixed interest and blue chip shares.

The table below gives the type of return you can expect reasonably over the very long term, by which I mean 10 years plan. This is a "real" return, meaning the return in excess of inflation. It's important to look at long-term returns because short-term returns (under these years) are very unpredictable.

As you can see again, the higher the risk you take, the higher the expected return. Conversely, if you take very low risk and put all your money into the bank, your long-term returns will be very low.

Investment Risk Projected real annual long-term returns
Cash in bank Very low 0% to 1%
Term deposits (1 to 3 years) Low 0% to 2%
Long-term fixed interest and bonds (3 to 10 years) Medium 0% to 3%
Residential property Medium 1% to 3%
Commercial property Medium-high 3% to 5%
American Shares High 5% to 8%
International Shares High 6% to 9%
Emerging markets (e.g. South-East Asia, Latin America) Extremely High 10% to 25%

The trick to managing risk is to consider how much risk you can tolerate given your personal situation, and then to build a portfolio of assets that suits you.

Put simply, a youngster with $500 may be happy to take a very high risk. This would see a 100% exposure to shares. A middle-aged person may want to be moderately aggressive and invest in a mix of medium- and high-risk investments. A retiree is likely to take low-risk approach and invest mainly in low-risk assets like cash and fixed interest with a smaller exposure to high-risk investments such as shares.

Speaking of high risk, you may be wondering about the projected long-term returns of 10% to 25% form emerging markets given the savage downturn in these markets in 1997 and 1998. Well, this is nothing terribly new. Despite the dramatic decline, nothing alters the fact that Asia is occupied by millions of people who want to get ahead and are willing to work hard.

When we look back in a decade or two we will certainly see major ups and downs in the market, but over long-term periods investment in a well-diversified emerging markets portfolio will see solid returns.