How to avoid risk when investing

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“I wouldn’t invest in the stock market, it’s too risky”

My colleague, 2021

Investing is often portrayed by the media as some sort of giant casino. The image in many of our minds is of chalkies running back and forth amongst an absolute din of noise, whilst wealthy investors make large “Bets” on the next big thing.

If this is the way you approach “investing” in the stock market, it truly is risky. This sort of short-term speculation is gambling. Exciting for some, but completely different from the boring investing that is likely to provide good long-term returns.

Really long-term investing in broad-based index funds is the exact opposite of gambling at a casino.

The casino is rigged to make a consistent and reliable profit. Over the long term, despite exciting moments and wins along the way, gamblers are guaranteed to lose. In contrast, with passive broad investing, you are guaranteed to win if you stay invested long enough.

The certainty of investing gains probably only comes after 20+ years of investing, however. But you are highly likely to do well over 5-10 year periods as well.

Investing for under 5 years? No one can tell you how your investments will perform. More than 50% of the time you will gain, the rest of the time you will lose. This is why most investment information sources suggest a minimum time frame of 5-7 years to invest in the stock market.

Wanting to Avoid Investing Risk Altogether

“Successful investing is about managing risk, not avoiding it.”

Benjamin Graham

No one can completely avoid risk in investing or life. Crossing the road, eating a meal and even walking involves some risk of death according to this cheery site.

As with most things, it is not about avoiding risk altogether (it’s impossible) but minimising risk, weighing risks against likely benefits and minimising controllable risks.

When selecting an investment, the first thing we should look at is risk. This is important to consider before getting seduced by the promised returns. Exceptional promised returns often involve large amounts of risk (or downright scams).

There are many different types of investing risk, but some of these you have some control over.

Investing Risk: Inflation Risk

Inflation risk is almost inevitable. Over time, the price of goods and services goes up. It’s not really noticeable (usually) in the short term, but is obvious looking back at historical prices.

Your parents have probably thrilled you with long stories about their first job paying only $20 per week. Wages increase (hopefully) to compensate for the increase in the cost of living or the other way around. Everything gets more expensive.

The Reserve Bank of Australia aims to keep inflation at around 2-3% per year, over the long term. A little inflation is healthy for a growing economy. Too much, or too little is generally bad news for the economy.

If you hoard all your extra income in a savings account earning around 1%, your emergency fund is actually decreasing in real value (aka purchasing power).

If $30,000 was enough to fund 6 months of living expenses in case of an emergency in 2021, in 2031 you will need over $40,000. And that is assuming you have completely resisted lifestyle inflation!

Including interest earned, you would have only $33,138.

This leaves us with two options to maintain an appropriate emergency fund

  1. Ensure your emergency fund is earning more than the rate of inflation (hopefully remaining 2-3%).
  2. Keep adding a little extra to your emergency fund each year to compensate for inflation

It also makes it obvious that saving large amounts of money in a bank account is not getting to get you very far. If you want to outearn inflation over the long term, investing that extra is more likely to achieve your goals.

Australia has been living through a period of unusually low inflation recently. Due to the quantitative easing instituted in response to the COVID-19, there has been lots of talk about hyperinflation.

Risk in Investing: Longevity Risk

This is the risk, in the case of retirement savings, that you live longer than your savings last.

It’s a common and understandable fear among retirees. It is also a compelling reason to make sure your money is earning optimal returns for the risk taken.

It’s probably better to be alive and having to scramble to find some extra cash vs dead.

There is also the risk of the opposite – not living nearly as long as expected, and missing out spending all that dough!

Back up plans in case your investments don’t perform as well as you hoped can be formed. If you have planned to live off the income off your investments (eg investment property), the assets themselves may need to be eventually sold.

Continuing to earn money through a small part-time gig you enjoy can significantly reduce your portfolio drawdown. Earning $10,000 per year means you need $250,000 less in retirement savings according to the 4% rule. Renting a room in your home could provide some income, and company for those wanting to stay in their family home for longer.

Reverse mortgages of your principal place of residence have generally been a poor deal but could be used if all other reserves are gone. The aged pension is tiny, but many people live on this entirely. We are fortunate in Australia to have this government safety net for those that can’t provide for themselves.

Minimising basic living expenses and owning your own home outright can help the aged pension stretch to cover a reasonable standard of living. FIRE bloggers often live on not much more than the aged pension, whilst renting!

Sequence of Return Risk

Whilst no withdrawals are being made, the order of positive and negative returns make no difference to the end result. In the graph below a sequence of returns “A” were positive for the first 7 years and negative for the last 3 years. Sequence “B” includes the same returns in a different order – the negative returns occurred in the 1st 3 years. The portfolios are worth the same at the end of 9 years, regardless of the sequence.

Once withdrawals are being made from a portfolio, however, the sequence of returns is very important. The same sequences A and B are tested in the graph below. For the first year, 4% of the total portfolio value was withdrawn. For each year following, this original withdrawal was increased by 3% (accounting for inflation.

The lines representing the two scenarios meet on the top graph, but there is a gap in the bottom graph. Portfolio B underperformed portfolio A despite the two portfolio’s cumulative returns being the same.

This ties into longevity risk. If you are unlucky enough to retire immediately before a period of negative returns, you’re more likely to run out of dough.

You can mitigate this risk by

  • Having adequate cash savings to live off until the market recovers
  • Keeping your options open for the first few years after retirement to perform some paid work
  • Withdraw less than 4%
  • Reduce your spending in years of market underperformance

Investing Risk: Volatility Risk

Volatility is a retrospective view of variation in an investment’s performance.

The terms “risk” and “volatility” often seem to be used interchangeably. But most people would consider investing risk as the chance of losing a significant amount of money.

Some investments are more volatile than others. If you were to invest then fall into a coma for 30 years, this volatility wouldn’t matter. The cumulative returns would be all you would care about.

The biggest risks with high volatility investments are:

  • Your time frame. You need to be investing for long enough to ride out the volatility and get the good returns promised over the long term. 7-10 years minimum is commonly recommended for the stock market.
  • Your risk tolerance. If you panic and sell during a crash, you are locking in those losses. If you are able to ignore your investments until many years later (much harder to do than it seems) the volatility is likely irrelevant. There is more discussion on risk tolerance here.
  • Horizon risk – the chance your time frame will dramatically shorten due to a change in circumstances. Unemployment, for example, could mean you needed to withdraw your investments far earlier than expected.

Liquidity Risk

In the case of that sudden change of circumstance (unemployment), would you be able to access your investments to withdraw them?

This is known as liquidity risk. It is very individual whether this is a big concern to you.

If you have other more liquid assets (eg emergency fund), you may be happy to have a relatively illiquid asset (eg investment property).

If you think you may need to withdraw within a few years, you probably need a less volatile asset to reduce the risk of losing money when you withdraw.

Concentration Risk

This is the risk of having the majority of your assets in a single (or related) investments.

For example, a pharmacist lives off his income from the pharmacy he works at and invests in pharmaceutical companies (because these are within his zone of competence). If there is a major change to the profitability of pharmacies from legislative change, both his job and investments are at risk.

Another example may be to convert your super to an SMSF and use most of the balance to purchase a single investment property in your hometown. If something happens to the market in the area your investments are concentrated in, all your investments will suffer.

Market Risk

This is a risk of changes in the market affecting your investment, whether it be property, shares or bonds. Much of this risk can be reduced by diversifying investments. Putting your eggs in many baskets reduces your personal loss if one basket is dropped. Market risk can result from:

Event Risk

COVID-19 was an example. A highly unpredictable, dramatic event that affected all our investments (at least in the short term. It’s impossible to anticipate all potential events so some of this is out of your control. Event risk can be internal (change in management of the company you have invested in), or external (Global pandemics etc).

With property investing, there may be a new highway built close to your property causing noise pollution. Council plans should be checked prior to purchase, but new plans may arise years after purchase that can have a dramatic effect on your investment value.

Secular risk

Secular risk is a change in the competitiveness of your investment.

There may be new competition, such as Uber if you had invested in a taxi company, or a brand new block of flash apartments making your new 10-years ago unit seem old and daggy.

There may be technological advance that makes your investment obsolete (Blockbuster video).

Customer habits may change, damaging industries. COVID-19 was pretty bad for the cinema business.

Interest rate Risk

Those with borrowings (property investors and homeowners as well as high-risk investors borrowing to invest in shares) are affected by interest rates. Bond investors also care about interest rates, as bond values tend to go down when interest rates go up.

Currency risk

When investing or spending overseas, the exchange rate matters. Investing in the world stock markets is generally considered a good idea, as Australia is a tiny part of the world economically.

Exchange rate changes will alter the spending power of your portfolio in Australia, for better or worse. You can reduce this risk by “hedging” to your home currency for an extra cost.

If you want to retire overseas, hedging to your current currency makes no sense. The exchange rate to your planned country of retirement will make a huge impact on the quality of life possible with a given portfolio.

Credit Risk

Credit risk is relevant to those who invest by lending money.

Peer to peer lending is unsecured lending, offering good rates to investors and borrowers, but with risk to the investor if borrowers default.

Bonds are essentially like loans to companies, or governments. Lower rated bonds have a higher risk of default (and loss of capital).

Presumably, the global financial crisis is still a little fresh in our minds to be trusting mortgage-backed securities anytime soon. These sounded like a pretty safe investment, but banks were lending more and more aggressively until the entire system collapsed.

Legislative Risk

Governments can introduce new laws that can advantage, or disadvantage your investments.

An example would be the hotly debated issue of Franking credits. Franking credits were introduced in Australia to prevent double taxation. If you own a share in Woolworths, which pays a dividend out of the profit made this quarter, tax has already been paid on that profit at the corporate rate of 30%.

If you as an investor then receive the dividend and are taxed, the dividend has been taxed twice.

Instead, the Australian tax office provides a tax credit, known as a franking credit for the 30% tax already paid. If you are in the 45% tax bracket, you will only have to pay the 15% owed.

If you are paying no tax (because you are a retiree), you will receive a tax refund of 30% of the dividend. This is extremely popular with retirees and has encouraged a whole generation of “dividend investors”, who select investments because of their history of dividend payments.

If these Franking credits were disallowed, all those investors who had designed their investment strategy around the tax outcome will be disadvantaged. It would be a similar situation with negative gearing property investors.

Risk of Being Scammed

Most of us think we are too smart to get scammed. We are wrong. You cannot be too careful, and should always be watching for scams that get more sophisticated every year. Check out the new Netflix series “Money, Explained“. The episode on “Get Rich Quick” explains the psychology on why we are so gullible, and even the experts admit to getting scammed. It’s a great series, enjoy.

How to Manage Risk in Investing

I recently read a comment by Warren Buffet about pretending you only had 20 investing decisions to make in your life. Many of us change investment strategies too frequently. Spend your time considering carefully before committing to an investment, and plan to make it a lifelong investment. Consider risk first, and minimise as much as possible. Diversification reduces much of the market risk and is considered the only “Free lunch in investing”.

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Aussie Doc Freedom is not a financial adviser and does need offer any advice.  Information on this website is purely a description of my experiences and learning.  Please check with your independent financial adviser or accountant before making any changes.

This Post Has 2 Comments

  1. Trish Smith

    I didnt know we had a Royal Bank of Australia, first time I have heard of it

    1. docfreedom

      oops, making up banks now! I’ll correct it

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