The two most basic but important concepts of any investment is ‘Return’ and ‘Risk’. Let’s break that down.
What is a return?
Your super fund will invest your money to grow it. The money that grows from that investment is called a 'return'. When a super fund talks about 'performance', it is talking about the returns on your investment. For example, if you have $50 in an investment and your money grows to $60, you'll have received a return of $10.
Returns can be described as a dollar value or a percentage. Most super funds will talk about returns as a percentage of your investment. In this example, $10 return on a $50 investment is a 20% return on investment (ROI).
How does risk affect your return?
Different investments provide different rates of return. For example, some might provide 5% return, whilst others may provide 20% return. So should you go with whatever gives you the highest return?
Well, not necessarily.
You see, returns for investments are never guaranteed. Sometimes, you'll get the exact return your investment is predicted to provide. But often, what you get can vary greatly; sometimes you’ll get a lot more, but sometimes a lot less. This uncertainty is called 'risk', and is the reason why super funds always refer to returns as 'potential' or 'expected'. In other words – no promises.
Different levels of risk
There are different levels of risk associated with different investments. Low risk investments usually grow slowly but steadily. Meaning you can be quite certain of the potential return provided by your investment, however, the return is usually quite low.
As you start to look at higher risk options, the potential returns from your investment become greater, but with less certainty that you'll get that return. In fact, it's even possible for you to lose some of your super savings. This is referred to as a 'negative return' or a 'loss'.
Put them both together…
In summary, the higher the risk, the more return you could receive, but there is a greater chance you might not get a return at all. Over time, the two options play out differently. Low risk options are usually more consistent and stable, whilst high risk options can fluctuate more dramatically. It's a bit like comparing a gentle carousel to a rollercoaster.
Your super fund will put your super savings into one of these investment options to grow your money. You can't control what the return will be, but you can choose how much risk you want to take on by telling your super fund which investment option to use.
How does return factor into the real world?
The two big concepts to remember here are ‘risk’ and ‘return’. Now let's talk about them in the context of superannuation.
First, returns. Super funds invest your savings in order to make a return. For all its work on your behalf, the super fund will charge you a fee. These fees will be taken out from any returns made on your investments. The remaining amount is called a 'net' return, and this is added to your savings. For example, if your super fund helped you make a return of $100, and charged you a fee of $10, then your net return is $90. The higher your fees, the lower your return. It's important to understand that super funds will charge a fee even if there is a negative return.
Super funds talk about risk in a slightly different way to how we discussed it earlier. When funds talk about ‘risk’, they usually describe it in ratings from very low to very high. How do they work out these ratings? By looking ahead for the next 20 years and estimating how many of those years they might get a negative return.
A low risk investment option means there's one year in which there could be a negative return. But a high risk investment could mean six or more years with a negative return.
Let’s have some fun
And that's risk and return – the two things that can grow your super. Knowing about risk and return will help you make better decisions. But even if you understand Risk and Return like a pro, super funds can perform differently from each other. Watch unit 4 to to get a better understanding about differences between funds.
For now, have a play around with the interactive activity in Unit 3, to see how choosing between low and high risk investment options can change how much money you have.