Goldilocks is known for her audacious trip to the three bears’ cottage – she samples their chairs, their beds and, most famously, their porridge until she finds what she describes as ‘just right’. Though a childhood fable, ‘the Goldilocks Principle’ is used in everything from psychology to astrobiology – and in this case to teach us a thing or two about investment risk…
What is investment risk?
On Goldilocks’s walk in the woods, she came across an empty cottage and went inside…
We all take risks every day, from trying new food, to going into an empty cottage in the middle of the woods… Investment risk often relates to the range of returns you can get on an investment which is usually measured by how much an investment goes up and down (aka volatility).
Risk often sounds negative, but taking risks can push you further along than you were before. While we’re not advocating breaking and entering, Goldilocks took a risk by going in the cottage – you could think of this like investing in the first place..
The Goldilocks Principle
Inside, she found three bowls of porridge. Upon trying them, the first was too hot, the second too cold and the third was just right.
Although cheeky, Goldilocks was onto something when she made sure everything in the bears’ cottage was ‘just right’ for her and changed things when they weren’t. And it wasn’t just Goldilocks – all the bears had their own porridge (and chair and bed) that worked for them.
No right or wrong risk level (or temperature of porridge)
The story can demonstrate that there’s no right or wrong when it comes to taking investment risks – it’s down to your own circumstances and attitude to risk. You can think of the porridge as an investment and think of yourself as one of the bears. Time to get your imagination whirring…
For example:
Mummy Bear – the high-risk investor
‘This one is too hot!’
Mummy Bear enjoys risk. She has a long time to eat her porridge in a morning because she doesn’t start work until 10, so she can take her time eating and cope with any ups and downs in temperature.
In investment terms, this makes Mummy Bear a more adventurous investor. She puts more of her money in riskier investments like equities, risking a bigger loss for the chance of a higher return. She has a long-term time horizon (how long she can invest before she needs the money) to wait out the ups and downs.
Daddy Bear – the cautious investor
‘This one is too cold…’
Daddy Bear likes cool porridge and a soft bed. He’s a wary one who likes to keep things comfortably padded, often hedging himself with cushions in bed and porridge temperature he can handle at any time of day.
In investment terms, Daddy Bear prefers protection away from riskier areas of the market. He likes more security around the level of returns he could get, even though they could be a lot lower than Mummy Bear’s. He might be getting ready to buy a house or is close to retirement and getting ready to withdraw, or maybe the thought of potentially losing lots of money to the stock market keeps him up at night.
Remember, all investments carry risk, even a cautious bear (investor) can lose money.
Baby Bear – the middle man
‘Ah, this one is just right!’
Baby Bear’s porridge is not too hot or too cold. He is somewhere between his parents – he likes to take some risks with temperature, but not so much that he’ll have to wait too long to eat it!
Baby Bear is a fairly balanced investor. He is comfortable taking some risk, but not as much as his mother. He’s happy with some ups and downs, but doesn’t want to see anything too aggressive or too low.
Asset allocation and diversification
Asset allocation is how your money is invested – how much of it is in a certain geographical region, a certain type of investment (equities, bonds, cash), that sort of thing. Diversification is about spreading your money across the different regions and types of investment, essentially not putting all your eggs in one basket – or porridge in one bowl.
Even the riskiest portfolios ensure they have diversified assets. Look at the portfolio of a successful investor and the chances are you’ll find a wide range of asset classes, from shares all the way to cash. This helps your portfolio cope in the volatile world of investments – if one area you’re invested in does poorly, your portfolio should manage because it’s invested elsewhere too.
Asset allocation can have a massive impact on your returns, so it’s important to get it right.
You can find out more about both of these here.
What should you do?
Well, the bottom line is that investment risk is a personal choice – just like the temperature of porridge, but there are three things you should take into account when thinking about it.
1. What is your appetite for risk?
Do you enjoy taking risks like Mummy Bear or do you prefer erring on the side of caution like Dad? What are your goals, how much money do you want to get out of investing? (Psst, remember, all investments can go down as well as up and you can get back less than you originally invested.)
2. How long are you investing for?
If you have a long term horizon, you can usually afford to take more risks than if you want to pull out in three years, say (though we usually suggest always trying to have at least five years for investing so that any investment can try to weather stock market storms).
3. Your emotional reaction
If you just don’t like the idea of taking much risk at all and it will keep you awake into the early hours despite any monetary goals or time horizons, then it is often not worth it.
Risk can be good and bad
This wildly unhelpful statement is completely accurate. Taking too much risk could jeopardise your portfolio, but taking too little or no risk can limit your potential returns, particularly with interest rates so low. What is a good level of risk (temperature of porridge, firmness of bed, etc.) for you, might be way too low or high for someone else. It all depends on your goals, feelings and whether you need to take risks to get where you want to be – it’s different for everyone.
The bottom line is that you need to make sure you can ‘bear’ it…
Speak to us
If you’re not sure about your appetite for risk (or porridge), we can help. Our friendly telephone team are here to help and you can see if you need any more help from a professional afterwards. Call us on 020 7189 9999 or email best@bestinvest.co.uk.
