As a part of the work with clients we had the chance to hear many stories regarding their experiences when building up their financial stability. What personally interested me was a phenomenon occurring in many of those. A lot of our clients had been hesitant to start investing because they had wanted to avoid the notoriously infamous investment risk. If you show interest in appreciating your savings, any financial advisor or bank clerk is obliged to inform you about it.

Truly, this particular phrase is often mentioned without a proper explanation. You may often hear phrases such as “Stocks are riskier than bonds” or “By investing you are subject to market risk”. However, only a few will actually explain what it means.

Consequently, you create a mental block which makes you resist investing. Nobody wants to risk losing their hard-earned savings. Quite the opposite, you want to manage them wisely. If the results of investing are purely dependent on coincidences, just like a roulette, then, no shock, you will stay away from it.  

Furthermore, the presence of multi-level-marketing companies (pyramid schemes) and shady investment companies promising 50% returns within a year, doesn’t help either.

We try to explain things as a human to human, things which are mostly understood only by experts. That’s why I’d like to provide insight into what I’ve been taught by my professors at the university. I’ll try to make things as simple as possible without diving deep into the complex calculations and math.  

My goal is for you to be able to better imagine what exactly is meant by “investment risk”. I hope it will improve your ability to make informed decisions about your money. 

Risk-Free vs. Risky Investments 

Let’s begin by establishing a difference between two types of investments: risk-free and risky. 

Investment is considered risk-free when we can exactly determine the earnings beforehand. Imagine putting 100€ into a one-year term deposit where the bank guarantees you a 3% interest by a contract. If you abide by the contract’s provisions and you do not withdraw the money during the following year, it is nearly impossible for you to withdraw anything else than 103€. The interest is guaranteed by the contract and your deposits are protected even if the bank goes bankrupt. The sum up to which the deposit is protected varies from country to country, but within EU it is mostly up to 100, 000€.  

On the contrary, the risky investments are such where you cannot exactly determine the earnings it shall yield. You do have a certain expectation, but the final result might differ.

Let’s take a look at a simple example. Imagine you purchase an equity ETF for 100€. You know that the stock market grows at around 8-10% annually. So, you know that your ETF could be worth around 108€ after a year.

The reality, however, might differ significantly. The year might be a very good one, and your ETF will be worth 120€. Perhaps the global economy will struggle, and the value will remain at 100€. Or maybe the world will be hit with a crisis and the value may fall to 80€.

 This is the essence of what something being “risky” in finance – the uncertainty about the final result. In the end you may earn +15%, +2% or -10%. You cannot determine which of these numbers will be the closest to the actual result.

How Do We Measure Risk?

So, various final outcomes can be achieved with risky investments. Finance experts measure the risk as the difference between the returns achieved over time. Or in other words, how much can the final results of the investments fluctuate. 

Once again, let’s take a look at a simple example: Imagine investing into a new company focused on the production of EVs and into a well-established crude oil giant.

Investing into the new company is rather speculative. The company may even go bankrupt during its first year of existence (return -100%) in the worst-case scenario. On the other hand, its value may even triple (return 200%) in best case scenario.  

On the contrary, investing into an oil giant is safer. Despite the possibility of suffering a loss during a crisis, there is very little chance of it crashing within a year. After all, the people are still going to need the oil in order to function, and in case of lacking funds, it is still capable of borrowing them from somebody.

However, there is not that large of a growth potential when compared to the new company, as it is already a well-established business, which doesn’t have that many opportunities to innovate anymore. So, let’s say that the bad scenario could result in a 50% loss and the good one in a 75% appreciation.

So, which investment is riskier? Naturally, the one into the new company. The range of potential results is much greater, which constitutes greater potential gains but also greater potential losses. 

Now comes the important question. After how much time shall we evaluate the final return of the investment? What does the word “final” mean? The range of potential results after 7 days is vastly different from such range after 10 years.  

 That brings me to the point of this blog. The investment risk changes with the amount of time you are willing to leave your money invested. The very same investment which may be just as risky as gambling in the casino if realized only over a few months may have a very low risk if realized over a few decades.

Stocks vs. Bonds: Which are More Uncertain? 

Let’s have a look at a concrete example. In the following sentences we are going to examine possible outcomes of an investment into stock indices. We will gradually increase the investment period and observe the change in the range of potential returns.

We are going to use Finax 100% Equity portfolio as an investment tool. This portfolio is comprised of ETFs  which copy broadly diversified stock indices all over the world. Therefore, it contains thousands of companies from a large variety of countries. In other words, investing into this portfolio means investing into the entire global economy.

To better show as many possible scenarios as possible, I am going to work with a very long historical development of the portfolio, specifically from Dec. 1987 to May. 2024. The returns since the launching of Finax portfolios (Feb. 2018) thus represent the actual performance we reached during our existence.

Logically, the portfolios couldn’t have existed prior to Finax’s founding, so we are going to use model performance. We have created it based on the historical development of prices of ETFs and previous development of indices which the ETFs copy. For detailed method of such modeling, please read this blog.

What is important for you to know is that this historical performance does not constitute an actual appreciation of a real client’s savings. It is a simulation which accurately reflects how would this portfolio develop if Finax had had existed since the end of the 1980s. Its aim is to show you how investments work during an actual, life-long investing.  

 Firstly, let’s work with an assumption that your investment period is only going to be one year long. The result will depend on whether you picked and chose a good or a bad year. What does a “good year” translate to in terms of returns and how high could the potential loss be during the “bad year”?

Let’s calculate the various returns of the one-year period investments, which you could have possibly earned between Dec. 1987 and the present day. So, firstly we work out how much you would’ve had earned if you had started in Dec. 1987 and ended it in a year: Dec. 1988. Then we work out the return from Jan. 1988 till Jan. 1989. And the cycle continues until we reach the return between May. 2023 and May. 2024.

 As a result, we will get a large group of various one-year returns, which you could have had possibly earned in the past (depending on when you would have had started investing). The most frequent values are depicted in the graph below. Taller the bar, the more returns appeared within the range written below it.

Notice that the returns are broadly scattered across numerous ranges. Most of the time you would have had earned between 0% and 15%. Moreover, you had  a solid chance of hitting a period where you would have had earned between 20% and 40%. On the other hand, many of the one-year investments had ended in a loss between -5% and -40%, with the -40% also being the biggest one-year loss that had occurred.  

I’d furthermore like to add, that this is how the previous returns are spread out. In the future, the one-year returns may be different from the ones that we’ve just shown. So, there is a possibility that sometime in the future we may experience losses exceeding 50% or profits above 50-60%. What I’m mainly trying to do here is to illustrate how likely is it for a particular return to occur.  

 Interested in how would such graph look with bonds? Let’s take a look at the same data, but this time for the Finax 100% Bonds portfolio. The graph showcases why are the bonds described as the less risky investment. The possible result spread is much narrower.

Since 1987 we haven’t experienced a single period where the portfolio had had dropped by more 20% (although even a loss greater than 15% was also extremely rare). On the other hand, the globally traded bonds had never earned more than 35%. The vast majority of the investments had yielded a return between 0% and 10%.  When compared to stocks, the probability of reaching an extreme value on either side is lower. 

Time Increases the Certainty 

Any wise investment advice will go on about the one same thing: Make your investment into stocks a long-term one. What would have been the results of a one-time investment into stocks, but for a five-year period instead of a one-year one? Take a look at the graph below!

Note: the returns are calculated as per one year (p.a.). So, if the graph below depicts a 4% return, it means that you had earned an average 4% return during each of the five years you had kept your investment.

Notice how the range has narrowed. There are not as many extreme values on either side. Even if your investment had resulted in a loss, the vast majority of those was in a 0% to – 5% range. In the absolutely worst-case scenario, you would’ve had lost 27% altogether (average loss of 6% p.a.) which, I think, is a bit better than the 40% maximum loss you could see in the one-year investment period.

In comparison to the previous graph, a larger portion of investments ended up being profitable. More than 85% of the investments had yielded positive numbers over the five-year period while over the one-year period, only 70 % could tell the same story. The likelihood of an investment not ending in a loss has thus grown.

As you can see, a 100% Equity portfolio is still not the most certain tool over a five-year period. Investors shouldn’t stick to it if their goal is less than 10 years away. In such cases, they should opt for mixed portfolios which combine both stocks and bonds, in order to lower the risk and increase the likelihood of profit even over shorter investment periods. If you need help with choosing the portfolio with the best ratio of stocks and bonds for you, you may use our robo-advisor to assist you.

 So, let’s stretch the investment period even further to 10 years. You may see the results in the graph below. 

In this case, the likelihood of the investment ending in a loss is miniscule. Only 7,5% of the investments would have had yielded a loss over a ten-year period, while the greatest loss reached only 2% p.a. (altogether 19% of your savings over 10 years). In the best-case scenario, your deposit would gradually quintuple.

The risk’s nature slowly begins to change. Even though you still may end up yielding a loss, the likelihood of that happening is much smaller when compared to short-term investing. At the same time, the greatest possible loss also fell. It is not as though you were in a casino, losing half your money for not betting on the right color, anymore.  

If you’ve been following us for a while now, you know that investing into stocks should not be a 10-year matter. It should be a habit, which you shall carry for the rest of your life. Investing should be just as ordinary of an expense as going grocery shopping: you spend a portion of your salary each month without thinking too much of it.  

 Investing like this will put your money to work for entire decades, easily for 20, 30 or 40 years. How will the graph look now you may ask? Let’s look at the results of 20-year investments:

As you can see, the loss is no more. If you had kept your money invested for at least 20 years, you wouldn’t have had hit a single period where you would suffer a loss since 1987.  

Furthermore, notice how narrow is the range of possible outcomes. In the worst-case scenario, your money would have had appreciated by 3% p.a., which would mean a total appreciation of 85% over 20 years. In the best-case scenario, your return would reach 10% p.a. which would septuple your savings. Either way, you beat inflation, you do not lose, only gain in each case.  

Lastly, there’s one more thing that I need to mention. Upon looking at the graph, you may be worried that investing doesn’t work that well as you can still hit an unfortunate period with only 3% average return p.a. It is important to realize that, only a few will invest their entire life savings during one month and will never ever save again. 

Quite the opposite, if you invest a portion of your salary regularly, then you’re purchasing investments over numerous years and months. Some deposits may earn 3-4% p.a., but some hit a period with a 10% return p.a. Thanks to this you will appreciate the money through an average, which is usually at 8% p.a. I believe you’ve already heard this number a couple of times from us.

Summary: A Growing Likelihood of Ending up Being Profitable 

The last graph summarizes how many of the investments over the various investment horizons between 1987 and 2024 ended up being profitable. As you can see, the longer the investment period, the greater the likelihood of ending up being profitable.  

Over a one-year period 70% of investments ended up being profitable. This percentage has gradually increased to a solid 100% over a 20-year period. So, if you would have had kept your investment for 20 years, you couldn’t have had hit a period where you would lose. The time is the best cure for market risk. 

A Few Last Thoughts on Risk 

In investing, the risk doesn’t always mean the same thing. If you plan to invest your money into stocks but withdraw them after 1-3 years, your success is not guaranteed.

In the case of such short-term deposits, we recommend avoiding stocks and opt for conservative strategies instead, as they are specifically designed for this purpose (e.g. like our Smart Deposit or highly cautious strategies such as Intelligent Wallet).

If the goal is from 3 to 10 years away, you still shouldn’t put everything into stocks. Ideally, opt for a mixed portfolio which mitigates the risk by combining stocks and bonds. You don’t have to worry about choosing the right mix, our robo-advisor will assist you.  

However, if you plan to invest long-term, in order to gradually cultivate your life savings, the nature of the risk associated with stocks changes. With a decades long horizon, the question changes from Whether? to How much? you earn. 

To be clear though, I don’t want to say that 20 years is some magical turning point from which it is impossible to end in a loss. Everything is possible, maybe the future will bring an unfortunate 20-year period with an extremely long economic crisis, but nothing like that has ever occurred. We can confidently proclaim that it’s not fair to compare life-long investing to playing roulette in a casino. 

One of the most well-known financial author, Morgan Housel, stated it very nicely. In his book, The Psychology of Money, he states that by long-term investing into index ETFs you’re essentially betting on humanity and the world economy being more developed and productive in 20-30 years than it is now.  

Can you imagine how the global economy looked like 30 years before, in 1994? Hint: that was 4 years before the foundation of Google, 10 years before Facebook and 14 before the introduction of the first iPhone. Can you even imagine a world without, the internet, social media or smartphones. Probably not. And investing into index ETFs is the way how to benefit from this progress.

What needs to be said, however, is that this conclusion only applies to investing into global stock indexes, not for picking and choosing stocks of concrete companies or only from certain countries. No company can guarantee that it will survive the next 20-30 years. It may go bankrupt, pushed out by the competition or its products will not be necessary anymore thanks to innovations. So don’t speculate over picking the “right stocks” and instead invest into the economy as a whole. This always grows in the long run.

So, if you are one of the people who are utterly disgusted by overly risking their money, trust me, I understand you completely. However, if you decide to completely reject investing because of that, you will be guaranteed to lose, as the inflation will gradually eat your savings. The best way of mitigating the risk is therefore choosing long enough of an investment horizon and make investing a life-long habit. 

You can start today. Opening an account at Finax takes just 10 minutes. We will be honored if you decide to begin your investment journey with us.