Risk is not a dirty word. We have to take risks to get the rewards that come from them.
Going to university is a risk. You may choose the wrong subject, drop out with no qualification. The reward can be a far better career. Taking a new job is a risk. What say your new boss is a tyrant, or the company goes bust? The reward could be earning more and climbing the ladder.
Investing comes with risks as well, whether it’s choosing a KiwiSaver, buying a house, buying shares, and so on. We need to take calculated risks financially to get ahead.
While a conservative KiwiSaver fund, for example, allows people to sleep at night knowing they’re very unlikely to lose their original capital; a growth fund will turn into a far larger pool of money over time.
Looking at the ANZ’s KiwiSaver funds, for example, its super low-risk Default KiwiSaver Cash fund has returned 2.3 per cent after fees on average for the past five years, according to the Financial Markets Authority’s FMA KiwiSaver Tracker. The same bank’s Default Growth fund has returned 4.8 per cent after fees for the same period to March 30. Some growth funds have returned more than 10 per cent over five years.
Growth funds jump up and down a bit as markets go through good times and bad. Those ups and downs are part of the upward trajectory that leaves you far better off financially in the long run.
The issue is how our brains respond to risk, says Ananish Chaudhuri, professor of experimental economics at the University of Auckland. It’s an evolutionary response. The minority of us are risk-loving and the majority are risk-averse. It’s a continuum and you may be somewhere in the middle.
A big issue is humans aren’t good at building models in our minds that enable us to balance risk and reward. So we take too little risk and go nowhere, or we buy super risky investments and lose our shirts. Sometimes we don’t know what’s risky and what’s not. Finance company debentures in the late 2000s were a classic example of high-risk investments bought by low-risk investors.
Our risk tolerance isn’t always logical. We buy lottery tickets because we overestimate small probabilities, says Chaudhuri. On the other hand, we don’t give enough attention to large probabilities.
Nor are we good about weighing up future outcomes. “This means that we put much less weight on the future or future income streams than we should,” says Chaudhuri.
Nor do we have a good sense of the underlying risks, says Chaudhuri. “Partly because this can be complex and partly because we are not adept at it.”
Getting more comfortable with calculated investment risk can be a good thing; providing you don’t need the money in the next five years.
The Catch 22 is that changing your perception of risk in either direction isn’t easy.
I always find stepping back when there’s a downturn in the market helps. Providing you’ve spread your money wisely (and most KiwiSaver funds do that for you) your investments will recover. Sometimes in months, but it can take three to five years after a particularly brutal “crash”.
Chaudhuri’s approach is to seek lots of advice. If you know people who have done what you want to, such as buying a house, ask what strategies they are using. “What are they assuming about what will happen to jobs, income, interest rates?”
Doing whatever it is you fear and gaining experience helps overcome your biases. It’s what a wave of new investors are doing on investment platforms such as Sharesies. They’re investing a few dollars at a time and learning by their mistakes.
Another way of gaining this experience is to borrow from other people’s experiences, says Chaudhuri. Investment forums, books and podcasts can be a good way of learning from this collective experience.
Not all of these experiences will be accurate or useful to you. “But if you aggregate all of that information you will start to get a good sense of what is feasible and what is not.”
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