Building wealth is all about risk

Building wealth and keeping it seem like simple, obvious goals. Ones we all strive for in our lives. But they don’t work well together. That’s because the risk you take to generate gains can also generate loss.

This means the critical question for every investor is ‘how do I maximise gains and minimise loss?’.

All forms of investment involve risk: cash is likely to hold its value but can lose it if inflation rises, shares’ value tends to rise over time but can drop amid a selloff, and property value tends to increase long term but can fall if interest rates rise.

Generally, you can expect lower rates of return from safer investments, such as cash or bonds; and for riskier investments, such as shares or property, greater potential returns.

Why wouldn’t you always choose the riskier investment option if it means greater returns? Because that risk might be too much to take on for your life stage. This is a concept worth explaining.

People tend to accept more risk earlier in their working life as they have more time to overcome any losses that riskier investments could generate, just as they could benefit from any higher returns. While older people, who may already draw income from their investments, are less likely to want to put those investments at risk, preferring to preserve what they have. (Decreasing risk as you age is the investment structure of our lifecycle MySuper option.)

Let’s take an example. Investment markets performed terribly during 2022. If you were invested in smartMonday’s international shares index option you would have lost 13.3% that year. That could be a devastating loss for someone looking to retire. If they’d put all their savings into that option, more than 10% of their wealth could have been wiped out. If they’d invested in a safer option such as our cash option they would have lost nothing, but made small gains, which is what you’d typically expect from such an investment. For someone earlier in life, losses from our international shares index option in 2022 would be a disappointment soon forgotten if that option kept performing at its annualised return rate of 12 per cent (for the 10 years to the end of 2022). In time, those gains would eclipse that particular year of loss.

But age and time isn’t the only way to manage investment risk. Diversifying investments is a central strategy that investors use. With this approach, while one investment sector (such as bonds) may decline in value, another (such as shares) may hold or increase in value – that diversification helps to manage the risk of any decline. For example, an investment option such as smartMonday Balanced Growth is diversified across local and international shares, property, cash, fixed interest and more. Its purpose is to balance the risk you face with a healthy allocation of defensive investments (which are explained below) and a higher proportion of riskier investments to maximise returns.

A third important principle is to invest in what you understand and find trusted money managers and advisers to assist you. People who rushed into Bitcoin in late 2021 when cryptocurrency hype was peaking found themselves a year later with that investment approximately halved in value. Many of those people may have expected its spectacular increase in value to continue, not understanding the extreme volatility of the asset.

And before you begin any investment, really consider how much you can afford to lose. Because with even the safest investment, there’s always a chance of the unexpected happening, leading to loss. Part of that consideration is to know what your financial goals are. And to ask yourself what would a financial loss mean to you at your life stage? And what investment returns do you need to achieve in what time frame?

The last principle I’ll explain is defensive investing. As mentioned above this is investing in lower risk assets. smartMonday’s defensive pre-mixed investment option is mostly allocated to bonds, with cash and some alternative assets playing an important role. The purpose with this approach is to preserve wealth while still achieving some gains.

But investment markets cannot be predicted, and last year when the value of property and shares largely fell, fixed-interest investments such as bonds fell as well – it was an unusual across-the-board decline in 2022, showing that past performance of an asset class really isn’t a guarantee of its future performance.

Ed Tomlinson is chief investment officer at smartMonday.