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?
What is investment risk?
Risk is the chance that:
You won’t get the return you want because of inflation. You might have invested in bank term deposits, and you don’t realise that inflation has risen above the interest rate. For example, you are earning 2% interest, but inflation has risen to 3%. When you withdraw your money, it buys less than when you started the investment.
You won’t get the return you want because of volatility – market ups and downs. Let’s say you’ve invested in a higher-risk KiwiSaver fund, which holds lots of shares. When you go to withdraw money to buy a first home you find the share market has fallen lately and you have less savings than you expected.
You’ll lose some or all of your money. This risk depends on the financial strength and integrity of the company or provider. But it also depends on whether and how an investment is regulated.
What can you do to reduce risk?
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?
Two keys to handling volatility risk
Learn to stay cool when your balance falls. In a major sharemarket downturn, your balance in a higher-risk fund or portfolio of shares could halve, or even worse. Picture that, and promise yourself you will leave your savings where they are. History tells us that as long as you have a wide range of shares your balance will recover, although sometimes it takes two or three years. If you’re not used to volatile investments, but you would like to try them because of the higher long-term returns, put your toe in the water with a small investment. Most KiwiSaver providers will let you invest in more than one of their funds, so perhaps move a portion of your savings into a growth fund. Or start out with a small investment in one of the online share trading platforms. After you’ve learned the basics and been through a few market downturns and recoveries – to prove you can cope – consider switching more of your savings
Never be forced to sell a volatile investment in a hurry. To achieve this, invest money you plan to spend: - within less than three years, in bank term deposits or a defensive managed fund. - within three to ten years, in high quality bonds or a conservative or balanced fund. - in more than ten years, in shares, property or a growth or aggressive fund.
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.
Diversification - spreading your risk
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
Within one type of investment. You might hold lots of different shares – preferably in many different industries. This could be through buying all the shares yourself, or through investing in a managed fund that holds shares. Or you might hold lots of different bonds, or several properties, perhaps including commercial and residential properties. Again, you can use a bond or property fund.
Across types of investments. It’s a good idea to own some shares, some property, some bonds and some cash – in or out of managed funds. They almost certainly won’t all lose value at once.
Internationally. You can reduce your exposure to one economy by holding investments in several different countries. An easy way to do this is through a New Zealandrun managed fund, so you don’t have to worry about international tax issues and so on.
Range of terms. If you invest in term deposits or bonds, you could have some that mature soon and some that mature later. Then they won’t all come up for renewal at a time when interest rates happen to be low.
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’.