Episode 5

Risky business; why fortune favours the brave (and smart!) and why volatility isn’t necessarily a bad thing

Today on Finance & Fury, we’re talking about …risky business!

Why take risk at all when investing? There must be a reason some people are willing to expose themselves to unwanted troubles, to downward movement in their investments? As the saying goes, ‘fortune favours the brave’ but unfortunately you still have to get it right! You can be as brave as you like, but it can still go quite wrong.

Getting it right with ‘risk’ without actually taking much risk, is really the smart, brave thing, rather than the blind silly thing of jumping 100% into an investment off the hope that it will go up. In this episode, we’ll look at how to use risk to your advantage.

Fortunes are built by those who have been brave investing in good long-term growth investments because you do not have to work as hard, if you’re in the correct investment that’s growing for you behind the scenes as opposed to something that might go down in value making you have to work harder and harder to build that fortune.

Types of Risk

  1. Pure (Absolute) Risk
    • Events that happen where the outcome is either loss or no loss – there is no potential for gain.
    • Examples: A car accident, your house burning down, health conditions, or death.
  2. Speculative Risk
    • The chance of a loss or gain in an investment.
    • Measured by volatility, which is just a statistical measurement that can make things look ‘risky’, when they’re actually quite a good investment.

Why take risk at all?

  1. Why speculate? To win!
  2. You have to be in it to win it – staying out of this game, or never taking risk, is actually losing by default

Volatility in daily life

  1. Volatility is the movement of the price of an investment – either up or down
  2. As humans we are ‘volatile’ with emotions for example
    • Road rage
    • A volatile partner; you get home one day to a pan being thrown at you for being late, or you get home the next day and the pan has been used to cook a meal waiting for you.

Volatility in finance/investments (the boring ‘Stats’ definition)

  1. The changes in the price from the mean (average)
  2. Measured by Standard Deviation; the measurement of the average movement a share prices makes away (up or down) from the average price.
  3. A standard deviation of 1 means there’s a 100% possibility of movement from its average.
  4. The good and the bad
    • So, what’s bad about volatility? The downside movement! The potential for downwards movement, or loss in value
      Though of course, volatility goes both ways – it also measures the upside movement, or potential gain
    • For example – A2 Milk Shares (ASX: A2M) has a standard deviation of 421%, it can change in price by $2-$3 very quickly. Increased in price from $0.5 to $11.50 in 3 years.
    • Gains are movements away from the mean, so as you increase the price quickly, the standard deviation also increases.

Risk and Return

  1. Return = Total Income + Growth
    (minus inflation if looking at the real return in the long term)
  2. Growth = Volatility
    • The increase in value of the investment itself
    • The more volatile the portfolio is, the more it has the potential to grow – but it can also go down!
    • You can choose to reinvest income or have it paid to you in cash. For example –
      • You have an investment of $10k, paying an income of 4% ($400) p.a.
        If you’re invested in cash, which is paying 4% income out to you every year, you may choose to reinvest this income. Over time, the income your investment is generating increases from $400 to $592 in 10 years, and $876 in 20 years. So, in 20 years you’ve more than doubled your income from your original investment, by simply reinvesting the income.
        This asset doesn’t have any growth though it’s just cash sitting in the bank.
      • Now, let’s introduce growth into the equation –
        You have an investment that is not only generating 4% p.a. income, but also 4% p.a. growth. You reinvest your income as in the previous example. Over time, the income your investment is generating increases to $868 p.a. in 10 years, and in 20 years it’s $1,864. From a 4% increase in growth, you have an additional $1,000 p.a, which is more than double what you would have if invested in cash.
      • The only difference between these situations is the volatility of the investments – one is considered risky, the other one isn’t.

What causes share price risk?

  1. Supply – Number of share listed/available to purchase
  2. Demand – How many people are buying or selling the share

Price Factors: No crystal ball

  1. Business environments go through peaks and troughs (resources)
  2. Companies face competition
  3. Technology changes
  4. Poor management
  5. Legislation/Political Risk

How to avoid it?

  1. Similar to relationships, you get to know the signs
  2. Never had a relationship? Well, you might not know the signs
  3. If you have gone through them over and over, maybe you either love volatility or you can’t tell the signs either.
  4. But if you can tell over time, you are learning
  5. You invest in relationships, hard to know beforehand.

Here’s what to look out for with your investments: Ways to avoid Risk of loss

  1. Avoid over demanded companies – Bubbles
  2. Risky investments –
    • Ongoing lack of profitability
    • Underlying asset unstable – e.g. Agribusiness
  3. Overextend – Too much debt/leveraged
  4. Eggs all in one basket – No diversification

Summary

Beyond not taking relationship advice from me, do yourself a favour, get some good growth going – but do it right! In next week’s episode, we talk about covering yourself for when things do go wrong. In addition, we cover off topics like diversification, and not over extending yourself.

Until then, if you have any questions, please get in contact. We love hearing from our listeners – whether you have a topic or a question you want us to discuss, or you want to give feedback head on over to our Facebook page, or through our website contact page

Think someone you know might like to learn more about how to manage their money? Go ahead, spread the love!

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