The Risks of Risk (Understanding Risk Part 3)

by Adam on May 17, 2010

In Part 1 and Part 2 of the ‘Understanding Risks’, we looked at how risk is really just the range of possible values at any point in time and how having a long-term horizon takes the real risk out of investing.

Investing, when done with a long-term outlook and with diversification -spreading your money around you help lower your risk of losing it all –is not as ‘risky’ as you may think.

In fact, the opportunity cost of not investing should be more scary to you by now (assuming you have read all the Magical Penny posts on investing so far!).

However, I’m not going to make any promises that investing is fool-proof.

The Risks of Taking Risk

You don’t need to dedicate all your waking hours to the subject of investing but you do need to be aware of the risks of taking ‘risk’ with your pennies. Here are the two main risks for someone in their 20s and 30s who are just starting out:

  • Not really having a long time horizon
  • Feeling greedy and taking excessive risk

You May Not Have a Long-time Horizon

The first risk of taking risk is about your time horizon. A long term view is important because when you invest in the stock market the value of your investment will fluctuate over time. The day-to-day price only becomes important when you need to sell; hopefully many years from now.

However, life doesn’t always go to plan and you may need money for an emergency or simply something you *really really want*. If you let your situation or emotions control your monetary needs you could find yourself selling your investments. This could be devastating on two fronts:

  1. You could be selling at a time when your investments have fluctuated down in value and may lose money. Bad times.
  2. You are forgetting why you wanted to invest in the first place: to help grow your pennies long-term. Spending your investments in the present means you lose momentum on your savings goals and you may find it harder to start building up your savings again.

The Solution

The solution is to make sure your investments really are for the long term by having enough savings in cash to both help you through emergencies and allow you buy the things in your life that are important to you without resorting to cashing in your investments.

Feeling Greedy and Taking Excessive Risk

The second ‘risk of taking risk’ for new investors is being too greedy.

I’m sure you’ve heard stories about someone who invested only a small amount in a company stock that then grew by 500%, thus securing their financial freedom.

Or the ‘tip’ to put all your money in China because it’s a country experiencing huge amounts of growth.

But remember what risk really is: the possible range of return over a certain period time due to the level of unknown factors.

For example…

China is considered risky because we, as investors, do not know how China’s economy will perform in the coming years –there’s potential for huge growth, but equally there’s potential for corruption, unknown problems and underperformance compared with expectations.  You therefore need to balance your portfolio so if the value of investments in Chinese companies fell to the low end of possible values you would not be in too much trouble because you have other investments.

The Solution

When you begin investming you’ll need to avoid to being taken over by greed by diversifying your investments (investing in lots of different places). Yes, you will not get as good a return as if you had only put your pennies in a few amazing investments, but you will have saved yourself from the risk of losing your pennies if those investments don’t return what you expect.

It’s easier said than done but Magical Penny is here to help you navigate the options.

Before we do, look out for Wednesday’s post where I’ll share a real-life example of how I dealt with trying to avoid greed whilst taking advantage of having a long-term horizon, resulting in being able to double my invested pennies in only a few months.

Further Reading

‘Buy and Hold’ is the Magical Penny investing strategy of choice. However, I found this counter-argument a fascinating read and very topical given the current series of posts on investment risk:

  • The Risks of Buy and Hold Investing

Previous post:

Next post: