All investments have an element of risk. But the word ‘risk’ has a different meaning in an investment context, compared to how people generally understand the concept of risk. In particular, what makes something “high risk” isn’t as obvious as it may seem. Understanding risk in the context of investing isn’t the same as general parlance.

Understanding risk

To be at risk is to be exposed to danger, harm, or loss. In investments, whenever anyone refers to risk, what they specifically mean is the chance that an investor will lose money. That’s the harm an investor might experience.

But here’s the thing: the chances of an investor losing all of their money is actually very low, because it’s a totally preventable outcome. The only way for this to really happen is for them to put all of their money into a single asset, which most competent financial advisers would generally recommend against. A single-asset risk can be entirely mitigated with a diversification strategy and investing in lots of different asset classes.

The risk an investor faces with a diversified portfolio is market risk. Every market has its ups and down. In the stock market, this is referred to as being “bull-ish” or “bear-ish”, but every market has these fluctuations: bonds, gold, oil, real estate, crypto, everything.

These fluctuations are referred to as volatility, and it’s this volatility that represents risk. Volatility makes markets difficult to predict. Over time, markets trend upwards. On a long enough time scale, it’s nearly certain that an investor will make money. But at any given point in time, the market may be down.

Risk = Volatility

With a diversified portfolio, the risk an investor faces is that the market will be down at the moment that they need the money.

So when an investment is referred to as being “high-risk”, most of the time what that really means is that the investment is volatile and unpredictable. Even though the asset is trending upwards, there’s a chance that the market might be down at the moment an investor needs to pull out their money.

The risk isn’t that an investor will lose their money, the risk is that they might have to pull their money out at a bad time.

On the other hand, a “low risk” investment just means it’s more predictable—it will generally grow slowly and steadily without many big dips or jumps.

A “high risk” investment strategy will make more money over a longer period of time, and the chances of investors losing their money isn’t necessarily any higher than a “low risk” investment strategy. Investors just have to be more flexible and know that their capital may be tied up in an investment for longer than they initially thought.

Let’s look at an example. The S&P/ASX 200 is an index of the 200 largest stocks on the Australian Stock Exchange. Here’s the trend line for the ASX 200 from January 1st, 2015 to December 31st, 2020.

And here’s the same chart updated with weekly data points, which shows how stock prices fluctuated.

“High Risk” doesn’t always mean high risk

These charts demonstrate that if an investors holds a “high risk” investment for a long time, the market trends upwards and they’ll make a profit, despite the volatility. Even during the massive drop caused by COVID, if an investor simply held onto their stocks, they would come out on top over time.

But on the other hand, let’s say that an investor bought in January 2018, and then a year later in January 2019 they had some kind of financial emergency and needed to sell their stocks to get cash quickly. They would be selling for a loss, because in January 2019 the market was down.

But in that same scenario, if that same investor could manage to hold on for another month until February, they would be making a profit again.

This is a simplified example, but it demonstrates the point: a “high risk” investment doesn’t necessarily mean the chances of an investor losing their capital are any higher, it just means that they need to be flexible around market conditions, and potentially stay illiquid for longer than originally planned. But if an investor can do that, they’ll achieve a higher return than if they played it “safe”.

We’ve used the stock market as an example in this article because the data is publicly available, but the principle applies to investments of all kinds: bonds, investment properties, real estate development, cryptocurrency. And of course, understanding risk mitigation strategies is incredibly important.

This is why it’s vital for investors to understand what their goals and time horizons are, and pick investment products accordingly to ensure a diversified portfolio. ∎