Understanding Investing Risk

The biggest misconception around investing is risk. Someone can get so fixated on the idea of risk, that is not only stops them from investing at all, but it also stops them from ever understanding what risk means.

You've probably heard people say "investing is risky!", without being able to say what exactly about it is risky. They might say something like, "well you could lose all your money, couldn't you?". They are describing an outcome, but they have no idea what could lead to it.

If we imagine this thinking elsewhere, there is extraordinary risk with driving, it can be as bad as fatal. I would say, that the risk of a fatal car crash is a lot worse than the risk of losing money in the stock market. If we were to take the same approach to driving as a lot of people do with investing, there would be almost no cars on the road.

Despite the risk being greater, we take the time to understand and take action to counter the risk with driving. We approach it with safety in mind. You might argue that driving is more critical to our lives than investing. But I'd say no. There are a lot of forms of transportation, and getting what you need from places you're not currently at. And now more people than ever are working from home. Driving has a lot of alternatives.

The alternative to not investing, is to settle for less, to work more, to work longer, to restrict your cash flow, to never retire, etc. The point being is that there's no real positive alternative to investing. Not investing today, means sacrifice in the present and sacrifice in the future.

The best way to overcome our fear of something, is to better understand it. A scary shadow monster turns into a tree branch, a startling sound is just a loud muffler of a cool youth, and what we thought was a surefire way to lose our money is really the best way to grow it.

What has always happened

If we want to have a better understanding of what can happen, we need to look back to get a better understand of what has happened. With investing, when we look back we discover that what has happened, has always happened. What I mean, we see a cycle of a similar pattern of events happening at different times.

The chart below shows the historical performance of the S&P 500, and highlighted are the most disruptive market events in history. During The Great Depression, markets dropped nearly 90% and took roughly 25 years to recover, and yet when we zoom out it's nearly invisible.

Because of the exponential growth that compounding creates, the further back a crash is, the smaller it seems (even if they fell a similar percentage at the time). One day even recent crashes will appear to be nothing but a tiny bump in the curve.

Stock markets have always been volatile, with crashes being unavoidable. Despite this, investing has been the best way to build wealth because the good years out number the bad years, in both frequency and range – the good times are simply longer and better than the bad. It always has been, and understanding this allows us to plan accordingly.

Investing shouldn't just be done for the sake of investing, it should be goal and value driven. With each goal having its own timeline and risk tolerance. Goals with a longer time horizon can typically take on more 'risk' or volatility in order to earn higher long-term returns. Adding bonds to the recipe mix to provide a margin of safety and stability. Different mixes of stocks and bonds have performed differently over time, as seen below.

Over a long period of time, the difference between expected returns can make a big difference. For example:

• $500/month at 7.21% for 40 years ends up being: $1,392,399
• $500/month at 9.21% for 40 years ends up being: $2,491,814

Understanding that the road to getting the long-term results we want will be bumpy, can help us manage our emotions when it eventually does (because it will). Understanding how we are investing, and why it's important to our specific goals, will allow us to be confident when the markets seem least confident. This has always been the case, there's always a thousand reasons to be pessimistic, and yet nothing compounds quite like markets.

The math behind investing alternatives

Let's say you're still not convinced, and you're looking for alternatives. You want investing-like results, without the investing part, let's specifically say the nearly $2.5M result above.

In that example, we'd end up contributing $240,000 or about 9.6% of our final result. If instead of investing, we simply saved and earned a generous 1% in a savings account, we'd have to contribute $4,224/month (instead of $500), for a total of $2,027,611 or 81.4% of our final result.

Investing efficiently does two things really well for us:

• It grows our money
• It saves us money

Earning 9.21% for 40 years allows us to grow our money from $240,000 to $2,491,814, for a total growth of $2,251,814. To get the same result without investing, we'd have to contribute $2,027,611 rather than $240,000, so you could look at investing as saving you $1,787,611 (or about $44,690 a year, after tax).

Imagine yourself in both scenarios, of course your dream retirement could come with a different price tag, but regardless of the number, the difference in results will be similar. Funding 80%+ of your retirement seems like an impossibility, the cashflow required to do so would leave most people without a penny to spare (I don't know anyone earning an 'extra' $45,000 a year).

Investing to fund your long-term goals is a no-brainer. Not only can you get your ideal outcome, but you can achieve it with less effort. Effort here refers to money, but also the required effort to earn the money. Having to contribute an extra $45,000+ to fund a retirement could easily require multiple jobs and sacrifices in almost every other area of your life.

It also plays nicely into the idea of not only optimizing your retirement, but optimizing your entire life. In Die With Zero, author Bill Perkins explores the idea that experiences that we want to have over our lives, are better pursued over different times in our lives. Instead of trying to pack our bucket list items into our retirement (and hoping we have the health for them), we would get more out of certain experiences by planning for them earlier in our lives. Physical activities like skiing, travelling, or backpacking would be good examples.

Having an efficient cashflow, while letting your investments to work for you, will let you achieve your goals easier, and with less effort. Ideally, this leads to both: your ideal retirement and your ideal path to get there.

Accurate expectations lead to better investing

We often see investing as a risky activity. Investing improperly can be incredibly risky, but I'd rather use the term gambling for those sorts of activities: going all in on one company, speculating, investing without a specific plan or outcome. But I'd argue that there's an incredible amount of risk by not investing.

Having a better understanding of the risks and realities of investing can let us assess the risk better, establish a plan that we can stick to through thick and thin, and control our emotions to avoid costly mistakes down the road. Better expectations leads to better results.

When we don't know what we should expect to happen, anything and everything can be a surprise – even something that has always happened. People often get surprised and panicked when the market drops, but the market drops all of the time, it always has and it always will. The good news it that it goes up just a little more than it goes down, and that's just enough to get mind-blowing results over the long-term.

Investing can either be as simple or as complicated as we make it. We have a lot more control and influence than we often admit. Of course, we can't control the markets, but by focusing on what we can control, we can shift the odds away from the house and heavily in our favour.

Keep doing things your future self will thank you for.