Investing involves risk.
Risk is an inherent fact of investing. Your willingness to take risks as an investor is an important part of why you can earn returns that exceed what you would earn by keeping the money in cash-this is known as the equity risk premium. For some, the idea of risk associated with savings produces fear, even panic.
Here is a guide you can follow to help you control the level of risk you take with your investments. The most determining factor is your time horizon, that is, the time during which you will not need that money, therefore, the time you remain invested.
At inbestMe, we strongly believe in investing as a way to build wealth in the long term, but we do not recommend trying to take risks with the capital we require in the short term. The main reason is that financial markets may have statistically predictable behavior over the long term, but they are totally unpredictable in the short term. Next, we will delve into the relationship between time horizon and probability of loss to help you become a more informed and confident investor.
Don’t risk the money you need in the short term
If you may need your savings in the short term, you should not invest it in a portfolio where its value fluctuates. The same applies to your first tranche of your emergency fund, which you may need immediately. That money should be in a demand account.
For the short term, say months or 1 year and a little more, or even a second level of emergency fund, we recommend a savings portfolio from inbestMe, which offers a Yield of 3.35% in Euros (5% in dollars if it is your currency). This type of portfolio allows you to get a very competitive return on your short-term cash or second-tier emergency fund-until you have more capital to invest-with almost no volatility, so you don’t have to worry: your funds are usually available within 5 working days. Obviously, you can opt for an interest-bearing account, but often the returns on these are close to zero.
If you wish to assume a minimum amount of risk in a medium-term time horizon, from 2 to 5 years, inbestMe offers you two alternatives:
- opt for a target portfolio: you now have available four options with maturities 12/2025,4/ 2026 12/2026 or 12/2027 that are composed of target return funds or ETFs with bonds maturing on those dates and designed to lock in a return and with less market risk than a diversified portfolio of index funds or ETFs. Target Portfolios would therefore be alternatives to deposits with those maturities, probably with more yield, but also with somewhat more risk, and are suitable if our investment horizon coincides with any of those dates. If not, it may be more flexible and more tax efficient to opt for option 2 below.
- Opt for a short duration Bond Portfolio such as the Conservative Bond Portfolio. This is an automated bond portfolio, which is composed of bond mutual funds and designed to outperform the savings account somewhat and with less market risk than a diversified portfolio of index funds (or ETFs).
Relationship between investment horizon and risk
When you save for the long term, say at least for a 3-5 year period, and especially when it is much longer, it generally makes sense to take on some market risk so that your savings have a chance to grow at a rate that outpaces inflation.
In such cases, not only the equity risk premium is involved, but also the bond risk premium (also called fixed income, but which also varies), which is mainly manifested by duration risk and credit risk. Combining these two main assets provides the benefit of diversification and optimal asset allocation.
There is a fairly consistent relationship between investment time horizon and probability of loss, which is an indication of the level of risk you are taking (although it is not the only factor).
The chart below illustrates the historical relationship between probability of loss and investment time horizon for US assets, where we have the most history.
As you can see, the probability of being in the negative decreases as the investment horizon extends. The chart shows the range of returns for stocks, bonds and a 70%/30% combination over different rolling periods of 1 year, 5 years, 10 years and 20 years.
Many conclusions can be drawn from it. The most obvious is that the longer we are invested (further to the right of the graph) the less dependent we are on chance. This is evident in the graph because the height of the bars becomes narrower, the averages being very similar in all periods:.
At 1 year, the randomness (the variability of the returns we can obtain) is extreme: extremely high bars.
At 20 years the variability is significantly lower, much shorter bars… and perhaps most importantly: the returns at the bottom are always positive.
This does not mean that you can only invest for 20 years, after 5 years the variability is significantly reduced.
Another conclusion we can draw is that investing with risk for only one year does not make sense, it is a lottery. In other words, if we invest with an asset allocation designed for the long term and we get scared in a few months, we are putting our savings in the hands of chance, which is why in these cases it is better to put our savings in a savings portfolio with practically no volatility or if you have a somewhat longer term a target portfolio that helps to set a return at the target date.
Another way to perceive the risk is to see the probability of loss in 1 year. In the following table we see that probability for a profile 7 (one of the most used in our diversified portfolios) together with the savings portfolio, the target and bond portfolios.
From this relationship between horizon and risk of loss, we can deduce the table above showing the minimum horizon to access each type of portfolio or risk profile.
Then, in the following table, we also deduce the optimal horizon range for each portfolio or profile according to the color (the greener, the more suitable).
In short, time is on the investor’s side. History shows that the probability of loss is statistically lower over longer periods, and a long time horizon has also historically given more time for any potential gains to capitalize. Keep in mind that making recurring contributions to your plan reduces the risk of loss.
Starting to invest can be intimidating, especially if you’re worried about losing money. That’s why understanding the relationship between horizon and risk is so important. It is essential that you do not cheat yourself and force the horizon to try to get more profitability. At inbestMe you have a wide range of portfolios to suit you and your profile as an investor.
Despite the uncertainty inherent in the future, having a diversified indexed portfolio and a broad time horizon can tilt the odds in your favor, making it easier to achieve your long-term financial goals. While the investment horizon is a crucial factor, we should not forget other significant elements that help define the most suitable risk profile for your portfolio.
Annex I: how to select the portfolio that best suits your needs
If you are clear about the type of portfolio you want to start with, simply go to the page where we give you the option to pre-select a portfolio type, select the appropriate option and follow the registration process.
If you are not sure which type of portfolio suits you best, click on “get a recommendation” and after answering a few questions we will recommend the portfolio that best suits your financial situation and objective.
Remember that you will be able to open new portfolios after you have contributed money to the first one, being able to fully plan your financial life in inbestMe, from the shortest term savings or emergency fund to your retirement and any other intermediate goal you may have for you, your family, even your children or your company.
