Key takeaways
Many people focus on repaying debt after buying a home, but fail to consider alternative and additional investments. Becoming comfortable with perceived risk is almost always a better approach.
Investment risk is the probability of not attaining the intended investment return. This can happen due to an erroneous investment choice or the inherent fluctuations in the market.
While volatility is a natural occurrence, when the investment fundamentals remain robust, volatility is merely about timing. The stock market, for instance, tends to follow a relatively predictable pattern over extended periods spanning multiple decades.
Start small to reduce perceived risk, and gradually increase your investment as your confidence and familiarity grows. Don't avoid or postpone investment decisions, because doing so may prevent you from achieving your financial and lifestyle objectives.
I believe most people spend too much of their lives trying to reduce perceived financial risk.
The opportunity cost of this approach is very high and puts lifestyle goals at risk.
Too much focus on risk reduction
Many people buy a home and then focus on repaying debt.
They then upgrade their home and once again, focus on repaying debt.
This cycle often results in a significant portion of their lives being dedicated to risk mitigation through a focus on debt repayment.
While repaying debt is not inherently wrong, the issue lies in adopting a mindset characterised by a limited tolerance for risk, which may not be beneficial in the long run.
More specifically, perhaps the mistake is to focus on debt repayment at the expense of considering alternative and additional investments.
Becoming comfortable with perceived risk is almost always a better approach.
Most people have the same risk profile
Safety and security are basic human needs.
Uncertainty makes most people feel uncomfortable.
These things drive people to aim to achieve at least a basic level of financial security.
However, the ultimate goal for most people is to have control over how they spend their time.
To work as much as they want, not because they need to work.
These are all very common financial and lifestyle goals that most people would like to achieve without taking unacceptable high risks.
Most individuals realise that all they need to do is earn an average return over a long period to fulfil their financial goals.
They don’t need to aim for 20% p.a. returns.
For instance, an investment yielding 7.2% p.a. will, on average, double in value every 10 years.
Consequently, the investment’s value will quadruple over a 20-year span, which is generally sufficient for most people to meet their goals.
Consequently, I believe that the risk profile for most individuals is quite similar.
In essence, most people are comfortable minimising as much risk as possible to achieve an average return over the long term.
Put differently, few are inclined to take exceedingly high risks for the sake of pursuing unrealistically high returns.
Risk is only a problem if you need to interrupt your strategy
Investment risk can be defined as the probability of not attaining the intended investment return.
This can happen for two primary reasons.
Firstly, it might be due to an erroneous investment choice – a low-quality investment lacking the necessary attributes for reaching the desired returns.
Secondly, the inherent fluctuations in the market can result in your investment not yet yielding the expected returns at a particular point in time.
Investment mistakes are not the result of chance; they are always foreseeable.
By adhering to an evidence-based and rules-based approach in your investment strategy, the likelihood of making mistakes becomes highly unlikely.
While volatility is a natural occurrence, it’s crucial to acknowledge that, when the investment fundamentals remain robust, volatility is merely about timing.
Take the stock market for instance, which statistically exhibits high volatility.
Approximately 95% of the time, annual returns from the stock market fluctuate between a 30% loss and a 50% gain.
This wide range is a perfect example of the inherent volatility of stock markets.
- Also read:How much of your income should you spend on a mortgage?
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However, over extended periods spanning multiple decades, returns tend to follow a relatively predictable pattern.
Holding an index fund for 30 years or more may expose you to numerous market cycles, yet returns are likely to revert to the mean, averaging around 10% p.a.
Risk mitigation becomes relevant primarily when there’s a need to prematurely interrupt your investment strategy before it completes its intended course.
For instance, if you find yourself compelled to sell your share portfolio after just 5 years of ownership, you could potentially incur a loss.
However, it’s important to note that such occurrences are uncommon.
It is education, not risk
If we set aside scenarios where external factors require you to interrupt your investment strategy, the relevance of volatility diminishes.
The year-to-year fluctuations in returns become inconsequential if the overall returns over a period of 20+ years, for example, are sufficient to meet your financial goals.
Perceived risk frequently stems from a lack of knowledge.
When investors are not familiar with a particular investment market or product, it tends to feel risky to them.
Consequently, I believe that the remedy for a client with a low risk tolerance lies in educating them, rather than altering the investment allocation and strategy.
Of course, it is true that a few individuals have an exceptionally low-risk tolerance.
However, these individuals are rare and certainly the minority.
For most investors, reducing perceived risk lies in increasing their understanding.
What can you do to reduce risk?
Every sound investment, market, and methodology can be explained in simple terms because they are often rooted in the same basic concepts, logic, and common sense.
Investors aren’t required to delve into intricate details; a high-level understanding of how investments work increases investors’ comfort and reduces perceived risk.
As such, educating yourself on basic investment principles is critical, and one of the reasons I wrote, Investopoly.
Seeking professional advice from a trusted professional can reduce perceived investment risk.
While knowledge is valuable, it becomes more potent when coupled with experience.
When you consult a professional, the paramount advantage lies in tapping into their wealth of experience.
The greater the experience of a professional, the higher the likelihood that you’ll steer clear of costly mistakes.
Most Australians lack investment experience and therefore should seek advice to reduce risk.
Starting small is another way of reducing perceived risk.
For example, if the share market seems risky, start investing small amounts in an ETF.
After a while of owning this investment, your confidence and familiarity will grow.
If you don’t take some risk, you may not achieve your goals
At first glance, avoiding or postponing investment decisions might appear to be a safer approach.
However, the truth is that embracing risk is essential for attaining our financial and lifestyle objectives.
Furthermore, investments often carry less risk than our initial perceptions suggest, particularly when we implement the steps discussed above.
Are you taking enough risk?
