Risk is your friend - you should manage it, not avoid it: Part 2/2

Earlier this week, I posted a wire about how, in my experience, many investors mischaracterise risk. That wire is here below:

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Risk is your friend - you should manage it, not avoid it: Part 1/2

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Today I want to posit some steps to rethinking that mischaracterisation. I’ll start with where we left off which is the idea of “risk-free”, and that it forms the basis of what some people consider “low risk”.

Categorically – there are no risk-free options. Not one.

You’re much better off understanding that and managing risk as opposed to trying to avoid risk. Even just managing the risk of losing money, just that risk, you need to manage many if not all of the risks in the long list from Part 1 (here again below). Together. At the same time.

• Liquidity risk
• Inflation risk
• Market risk
• Credit risk
• Currency risk
• Counterparty risk
• Regulatory risk
• Management risk

No one said it was easy.

One obvious and Australian-centric place that this misunderstanding of risk manifests often is in superannuation. Now granted, the superannuation-aware population skews older plus the big super funds have a liability concern to deal with, so I understand why they do this, but the big super funds are, in my view, very guilty of under-risking their communications with their clients. An excellent example is how often the balanced fund annual return is quoted, and the meaningful impact that has on the propensity for investors to choose that balanced fund.

To clarify, what I’m about to say is NOT personal advice and you should all speak to a licenced professional and/or your tax advisor before you digest this paragraph. Everyone’s situation is different and this is a general comment only, but setting aside individual circumstances and setting aside that an investor might have a very conservative disposition, anyone who is 40-and-under should essentially never have their assets invested in a balanced asset allocation in a super fund. Anyone who is between 40 and 50 should almost never be balanced. This table shows you why.

That balanced investor is not taking on enough risk and, ironically, it’s putting them at risk of not achieving their retirement goals, or beating inflation, or being able to stop working when they want. It’s the classic confusion of risk and fear – a 38-year-old investor in the balanced fund is either not sufficiently informed or at least a little scared of being in the stock market, maybe a bit of both.

Look at that table above - over the last 5 years (through 30 June 2024), Big Super Fund 1 took over 16 years to double your money in their Balanced fund. The MSCI World took 6 years. The Nasdaq 100 took a little over 3 years.

Another place you see the confusion of risk and fear is investment real estate, an allegedly “safe” investment option. The fear is that stocks move around every second of every working day so to mitigate that risk, an investor will buy real estate and assert the price is stable.

It’s not, it’s just that you can’t see it trade every second of every working day. Buying investment real estate (especially in the residential space) ignores the risk of illiquidity, it ignores management risk (unless you’re going to manage it yourself but even then, you’re relying on others), and it ignores the risk of opportunity cost given the yield is low, the costs are high, and the return is often below average. That said, if you want to improve or develop real estate, or you want to engage in the high-quality end of commercial real estate, that’s different. But two things – one, almost no one does that, they just settle into residential real estate investment, and second, now there’s a raft of other risks you’d be taking, risks that you should get richly compensated for.

I won’t go into the details but I wrote a two-part wire on this - trust me, investing in residential real estate is not a good growth option (see here for part 1, and part 2 is embedded in there, as is my piece on why US stocks are better at growth than Aussie stocks....just sayin’):

Property

Residential investment property is a sub-par way to grow your wealth – Part 1/2

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In the end, it doesn’t matter which investment option you take – stocks, bonds, real estate, or something else – there are no risk-free options. Equally, there are no wrong answers, there are only trade-offs. Knowing this going in, and then managing those risks and trade-offs accordingly is most likely the right approach.

In situations where you feel like those risks are too complex, or you know too little about them, or you’d rather not handle them, good news – you can hire a professional to look after it for you. And they will.

Getting this right can result in a potentially life-changing uplift in your retirement savings. Again, look at that table above.

Try to get it right but be warned – it’s not always easy.

Good luck out there.