There are investments available at all risk levels. The safest investments are government bonds and Kiwi Bonds, which are backed by the New Zealand Government. However, they often pay low returns.
If you take more risk, over the years you will usually end up with higher returns and therefore bigger savings, although you’ll have to cope with ups and downs along the way. However, there are ways you can reduce the volatility of your investments. But first, what exactly are we talking about?
Risk is the chance that:
It’s wise to invest the money you plan to spend within the next few years in bank term deposits or a defensive managed fund, because there’s very little chance of your balance falling. And inflation over a couple of years doesn’t make much difference.
But for longer-term money, you want returns above inflation. This usually means investing in something riskier – bonds or a middle-risk balanced fund, in or out of KiwiSaver. And if you choose shares, property or a higher-risk fund your returns are likely to be even higher.
This is the opposite to inflation risk. The very investments likely to beat inflation over the long term – shares and property – are the most volatile ones! How do you cope with that?
There are two key things to handling volatility risk:
If there’s a downturn in the markets, you have plenty of years before you need to withdraw the money, and by then it will have almost certainly recovered.
What's the worst that could happen?
People are sometimes forced to sell an investment for less than they paid for it because of a financial crisis.
Before making higher-risk investments or borrowing to invest, work through a ‘worst case scenario’. Imagine that you lose your income, or develop health problems, or your relationship breaks up, or your property has big maintenance expenses, or whatever else might mess up your financial situation.
Would you have to sell the investment – perhaps when the markets are down and you get a low price for it?
Thinking this way might seem negative, but these are the situations that set people back enormously, so it’s wise to be prepared for them. Make sure you have access to rainy day money, or the ability to add to a mortgage – or you have a generous relative! If you are in big financial trouble you may be able to withdraw KiwiSaver money, but that’s not an easy process.
The risk of losing money
If you follow the ‘rules’ above, you shouldn’t lose money because you had to sell a volatile investment when its value was down for a while.
But with some investments, the value goes down and stays down. Shares in a company that goes out of business will be worth nothing. And the value of a property in a neighbourhood that deteriorates may plummet.
Sometimes an investment with a finance company or adviser loses some or all of its value because of incompetence or dishonesty.
A good way to help protect yourself from losing money is to use investments that are regulated. The Reserve Bank watches over banks, and the Financial Markets Authority (FMA) watches over KiwiSaver providers and other fund managers, other licensed market services providers, and those providing financial advice.
The government doesn’t guarantee investments (although government bonds are, effectively if not technically, guaranteed by government). But regulation makes it much less likely you’ll lose money because of a financial provider’s misconduct.
Check the exit
It’s important to note that people sometimes lose money on an investment because, when they want to sell it, nobody is keen to buy.
Always check how you can get out of an investment before you go into it! Is there an organised market, like the stock market or property market? How long will it take to get your money out of a managed fund? In some investments, the managers say they will help you find a buyer, but when the time comes, the only buyers are real bargain hunters, if anyone at all.
Risk and return go together, as we’ve noted. The higher the risk, the more likely you will receive high returns in the long run, although there will be ups and downs along the way.
The reverse is also true. You can’t get high returns without taking risk. If anyone ever tells you otherwise, run a mile! They are almost certainly scammers.
Generally, you can’t reduce your risk without reducing your return. But there’s one exception to that. By spreading your money over a range of investments you greatly reduce your chances of losing a lot of money. And yet your average return is unchanged
Let’s look at an example. In a single share, the range of likely returns within a year might be minus 100% (if the company goes bust) to plus 200% (if the company does really well). And in a managed fund that holds many shares, the range of likely returns for each of those shares might be the same minus 100% to plus 200%.
But not all the shares will rise or fall together. When some fall others rise. And it’s pretty much impossible to imagine all the companies going out of business at once. So the range of returns on the whole fund is more likely to be, say, minus 50% to plus 150%. Your average return hasn’t changed, but your volatility has. Some experts call diversification ‘the only free lunch in investing’.
There are several types of diversification
It’s a good idea to diversify in all these ways. The easiest way to diversify is to invest in a managed fund.
This content is reproduced from ‘Hits and Myths: an introductory guide to investing by Mary Holm’.