Whenever I talk to a client about investing, at some point the conversation turns to risk. For most, I see a change in their facial expression where they start thinking of their money disappearing completely, with no prospect of getting any of it back. This is not what risk is about.
If you want to earn more than the risk free rate, you have to expose yourself to some level of risk. The more risk you expose yourself to, the greater the expected return.
The best starting place is finding out what return can you get taking no risk. German bonds, or loans to the German government, are considered to be as safe as you can get. These are used as the standard bearer of the risk free return.
So what return can you expect if you don’t want to take any risk? A 10 year German government bond currently pays interest of 0.62% per annum.
You have to be able to differentiate between good risk and bad risk. Investing in German bonds is good risk as the chances of losing your money is very slim indeed. Bad risk is investing in Greek bonds. The yield on Greek bonds is 11.26% on their 10 year bond, 18 times what the Germans have to pay. This is because the market thinks the Greek government will default and you won’t get your money back so they want to be rewarded for taking the risk.
To give the Greek government a loan, there is a much higher chance that you won’t get your money back. You are taking a much bigger chance in giving them your money and so you want to be rewarded. The market says that to give a loan to Greece, they want to earn an interest rate of 11.26%.
If you invested €100,000 in a German bond, you would earn €6,200 in interest over 10 years and you . If you invested in a Greek bond, you would earn €112,600 over the same period!! But there is a very good chance that at some stage the Greek government will default and you will get nothing. It is almost inconceivable that this will happen with the German bond.
This is where people really start to get jittery. Shares are volatile, their value goes up and down every day. Yes they do and because you are taking a risk of investing your money in a company, the company rewards your accordingly.
What that reward is depends on the shares you buy. Like in our bond example, there are varying levels of risk in shares too. The reward for investing in Coca-Cola or Microsoft is going to be much smaller (because there is less risk) than investing in a Start-Up where the potential returns are 10 times your investment or you get nothing (high risk).
A way of reducing risk is to diversify your portfolio, that is invest in lots of different shares and asset classes. How does that work?
Investing in Microsoft and Apple is less risky that just investing in Microsoft. Investing in Proctor & Gamble and Microsoft is even less risky as they are in different industries. Now multiply that by hundreds or thousands of different stocks from all around the world.
Bonds tend to do the opposite to stocks (but not all the time), so having some bonds and shares means that not everything will go up or down at the same time, which reduces your risk.
When investing, the key is make sure you differentiate between good risk and bad risk. You can either get a fund manager to analyse stocks and make the decision for you or invest in indices which track the top number of stocks in any category.
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