Regular readers will know I’m a big believer in the power of investing. It’s not just how much you earn and save which determines your wealth. It’s also about what you do with those savings – in other words, how you invest.
Investment platforms are like bank accounts for investing. Whereas your bank account only allows you to deposit or transfer cash, investment accounts hold your financial investments, for example in equities and bonds.
When you sign up to an investment platform, one of the first questions you’re asked is to determine your risk profile. For most of us, this is hard. This piece is designed to help you figure out the right risk profile for you.
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Volatility
There’s a common misconception that if an asset behaves like the line below, it’s risky:
This might seem fair at first glance, but it’s not right. This chart shows volatility - in other words, variability in value.
If you’re a long-term investor, volatility doesn’t matter all that much. In fact, you’ll be happy to take some volatility, if it means that your end result - when you actually need to withdraw your money - is better.
The volatility is only relevant when you sell – otherwise it’s about the upside between ‘A’ and ‘C’, not the loss from 'A' to 'B'.
Risk as Opportunity Cost
A better measure of risk is to think about how much you’re giving up by choosing one investment over another. Herein lies the concept of opportunity cost – what is the opportunity you’re giving up by making once decision over another.
What if I told you that by doing what you thought was less risky, you’d actually lose 90% of your money? You’d think I was crazy. But that 90% loss actually happens when we analyse risk through the lens of opportunity cost.
Imagine you could receive a return of 3% interest in your current account, and 8% on your portfolio of equities. And imagine this is a long-run investment portfolio, with a time horizon of 40 years.
After 40 years, every £1 in your current account would now be worth £3.26. That’s a gain of £2.26.
However, every £1 in your investment account would be worth £21.72 – a gain of £20.72.
Let’s show this in a chart. The blue line represents the current account; the orange line represents the investment account:
The gap between these two is your true risk. It’s the risk that you were following the wrong investment strategy all along. By choosing the current account, you forgo 90% of the gain you could have had by a long-term investment in equities. As the Americans say, ‘go figure’.
Your Mind Can Be Your Own Worst Enemy
The human mind is capable of great things, but it can also get in the way.
We tend to worry much more about losing what we have today, rather than what we could have tomorrow.
As such, 99% of us think about volatility rather than Risk as Opportunity Cost. That means we look to reduce the chances of short-term loss, even if we’re long-term investors.
If you’re a short-term investor, it makes sense to be concerned by volatility. If you need to withdraw money in a matter of months, you shouldn’t invest into the equity market.
But if you’re a long-term investor, you’re far better off thinking of risk as opportunity cost – because all you care about is how much you make by the time you need to withdraw your money.
So it all depends on your time horizon…
Go back to the original question. When these investment platforms talk about risk, they’re really talking about risk as max drawdown. Will you need to withdraw the money. Will you panic sell when your investments have lost value?
If you’re short-term in your outlook, then you’re a lower-risk profile.
But if you have no upcoming withdrawals, and can see through short-term volatility, you can embrace a higher-risk profile. And – as a result – you’ll reap the rewards.