Investing basics: risk, return, and when to wait

Investing is the activity of putting money somewhere it can grow, accepting that it might not. The two ideas that matter most are that returns are compensation for uncertainty rather than a reward for effort, and that time in the market does something that timing the market does not.

The purpose of this page is to make the concepts precise enough to reason with. It is not a recommendation, and the arithmetic below is the part that holds regardless of what you decide to do.

Quick answer

A return is a percentage change in value over a period, including any income received. Two figures are almost always left out of a quoted return, and both change the answer: inflation and costs. A return quoted without either is a nominal figure before charges.

What a return actually is

A return is a percentage change in value over a period, including income received such as dividends or interest. Two things are usually left out when a return is quoted, and both matter:

• Inflation. A 5 per cent return when prices rise 4 per cent is a 1 per cent real gain. A return quoted without the inflation context is a nominal figure.
• Costs. Fees, spreads and taxes are subtracted before you receive anything. A fund charging an annual fee reduces the return by that amount, and over a long period the effect compounds against you.

Why time does the work

Compounding means a return is earned on the previous return as well as on the original amount. Over a short period the effect is small; over a long period it is the dominant term, which is why starting early matters more than starting with a large amount.

The mirror image is also true: costs compound against you in the same way. A fee that looks small annually is a large amount over decades, and it is the most reliable determinant of outcome that an individual investor controls.

Risk, stated plainly

Risk is not the same as volatility, although the two are often used interchangeably. Volatility is how much the price moves; risk is the chance of a permanent loss, or of not being able to get your money when you need it.

The practical consequence is about time horizon. Money you will need within a year should not be in anything whose value can fall, because a fall at the moment you need the money is a permanent loss regardless of what the price does afterwards. This is why an emergency fund is held in cash — see the emergency fund for students.

Diversification, which is the only free lunch

Holding many things rather than one reduces the effect of any single one failing, without reducing the expected return proportionately. It is the one adjustment that improves the relationship between risk and return rather than trading one for the other.

The limit is that diversification does not protect against everything falling at once, which happens in a general market decline. It protects against the specific failure of one company, one sector or one country, which is a different and more common way of losing money.

Costs, which are the number to check first

Two products offering the same exposure at different costs produce materially different outcomes over time, and the difference is not small. Before comparing returns, compare what each product charges: the ongoing annual charge, any charge on entry or exit, and the spread between buying and selling.

A return figure quoted gross of costs is not a return you will receive. Where a product advertises a historical return, the useful questions are what the costs are and whether the figure is net.

What this page will not do

It will not tell you what to buy, because that depends on your circumstances, your time horizon and your tolerance for loss, and because a page cannot know them. Anyone offering a specific return or a guaranteed outcome is describing something that does not exist — the pattern is in avoiding scams and fraud.

The mechanics of borrowing costs, which is the mirror of investing, are in understanding interest and APR. The budgeting context is in how to budget as a student.

Three questions before investing anything

1. When will I need this money? If the answer is within a few years, the honest arithmetic says it should not be in anything that can fall.
2. What does it cost me to hold it? The annual charge, the entry and exit charges, and the spread. These are knowable in advance and are the largest thing you control.
3. What would I do if it fell by a third and stayed there? An answer formed in advance is a decision; an answer formed during the fall is a reaction.

The third is the one that determines the other two, and it is worth taking seriously because a fall of that size is a normal event rather than an unusual one over a long period.

What compounding does to costs

A cost charged annually compounds against you in exactly the way a return compounds for you. Over a long period the difference between two products charging materially different amounts is larger than most people expect, and it is entirely independent of which performs better.

This is why the first comparison between two similar products should be cost rather than past performance. Cost is known; performance is not, and past performance does not reliably indicate the future.