The annual return you actually get will often be in the middle of the curve. In the above example, the average return is 5%. That would be a fairly typical return. 

But your return won’t always be exactly 5%. Sometimes the return will be really high; sometimes really low.

But most of the time your return will be somewhere in the middle. 

The standard deviation measures how wide that bell curve really is. 

If an investment is high risk, the bell curve will be very wide. The investment returns jump all over place, so the standard deviation is high.

A lower risk asset will have a skinnier bell curve; your returns are mostly in the middle; not that much up and down at all. In that case, the standard deviation is low. 

Think of it like driving. A low standard deviation is like cruising at a steady 50 km/h. You’re at a similar speed the whole way. 

A high standard deviation is like driving through stop-start traffic. You’re sometimes crawling, sometimes flooring it. Both trips cover ground, but one feels much bumpier.

In this graph you see two bell curves. They have the same average return, but one of them is much more risky, so the bell curve is wider (it has a higher standard deviation). 

If you invest in the higher risk asset, the return you get will be very up and down.

But what is the standard deviation? 

The standard deviation can be a hard concept to get your head around, so it’s easier to get the idea across with an example. 

Let’s say that you’re investing in a managed fund. The average return is 5% and the standard deviation is 4%. 

Let’s assume your returns follow a normal distribution. That means you should expect: 

• 68% of the time your annual return will be within 1 standard deviation from the mean.
• 95% of the time your annual return will be within 2 standard deviations from the mean.
• 99.7% of the time your annual return will be within 3 standard deviations from the mean.

This is known as the 68 – 95 – 99.7 rule. And it’s the same across all normal distributions.

How do you apply that to investing?

Your average return (the mean) is 5%. 

So, 1 standard deviation above the mean is 9%. (The 5% average return plus the 4% standard deviation).

1 standard deviation below the mean is 1%. (The 5% average return minus the 4% standard deviation).

So 68% of the time (over two-thirds) you should expect your annual return to be between 1% and 9%.

95% of the time (the vast bulk), you should expect your annual return to be between -3% and +12%. 

That’s two standard deviations above or below the average (mean). 

That means most years you’ll make a small gain, but every now and then you could have a really bad year (like losing 3%) or a really good year (like making 12%).

This matters because two investments might both average 5% per year, but if one bounces between –10% and +20% while the other stays between +2% and +8%, they feel very different to live with. 

That’s why it’s worth understanding what the standard deviation is, and also looking at the returns of an investment in conjunction with the standard deviation, because that shows you the risk.

Property vs shares vs managed funds – what’s riskier?

Now we know how to measure investment risk we’re almost ready to compare property, shares and managed funds.

But before we get to that here’s how many people typically rank how risky different assets are. This is from the least to most risky:

• Conservative managed fund
• Balanced managed fund
• Property
• Growth managed fund
• Individual shares

However, this gives a false view of the risks of property. 

In reality, property is riskier than many people think for two main reasons: 

1) Your property isn’t the average property 

Many Kiwis believe property is a ‘safe’ investment.

If you look at a graph of the New Zealand House Price Index it appears to be relatively stable. House prices almost always go up. 

The line trends upward, with the occasional dip. 

And if you compare the NZ Property Index to the S+P 500, property looks less risky. See how the bell curve is wider for the S+P 500 compared to property?

But here’s the catch – the NZ house prices index is the average of about 1.8 million houses. That’s how many properties we have in New Zealand.

But when you buy a house, you don’t buy a share in all 1.8 million houses. You buy a single property. 

And the value of your property will be much bumpier than the average price of 1.8 million houses because averages smooth out those bumps. 

So the first thing you need to know is that your house will go up and down in value much more than the overarching index. 

And because of that you can’t compare shares and property by looking at the two indexes.

You can’t invest in the NZ Property Index. It doesn’t exist as a fund. Instead, you invest in an individual property.

But you can invest in the S&P 500 Index – a diversified basket of 500 US companies.

2) You probably have a mortgage ... and debt increases your risk

Property becomes much more risky once you add the mortgage into the mix. And that’s because of the Mortgage Magnifier effect. 

Here’s a simple example:

• You buy a $500,000 house.
• You put in a $100,000 deposit.
• The market goes up 10%.

Your property is now worth $550,000. You made $50,000. And you now have $150,000 of equity in the property (up from $100k).

But that’s NOT a 10% return.

It’s a 50% return because you started with $100k of equity. Now you’ve got $150k equity in the property your equity rose by 50%.

How did that happen? The debt. 

You only put in a fifth of the money, so you get 5x the market return. 

The mortgage magnifies the market’s return. That’s why it’s called the Mortgage Magnifier. 

But, it works the other way too.

Let’s say the market drops 10%. Your $500k property has gone from $500k to $450k. 

And your equity in the property has gone from $100k down to $50k. You lost $50,000 and your equity in the property has halved. 

In other words, you got a -50% return. That’s 5x the return the market received. 

That’s why your wealth in a property jumps around a lot if you buy a house with a big mortgage. 

So, buying a property with a 20% deposit (more debt) is riskier than buying a property with a 50% deposit (less debt).

Similarly, buying a property with a 50% deposit is riskier than buying a property with no debt.

We’re getting close to making our final comparison between property and shares, but first we need to discuss the risks of buying different shares. 

How risky are shares (really)?

Often investors refer to investing in shares as if it’s all the same thing. 

It’s not.

You might decide to invest in a fund that tracks an index. Or, you might invest in individual stocks. 

Just like the price of an individual property will be more up and down compared to the country’s national average, it’s the same with shares. 

The price of an individual share will go up and down more than the S+P 500.

And then there are the differences in stocks. 

Some are more steady (‘Blue Chip’ stocks) while others are more up and down (‘Growth’ stocks).

Here is a comparison between the S+P 500 index vs Walmart (a ‘Blue Chip’ stock).

An S+P 500 tracker fund is less volatile than an individual stock because your money is spread across 500 companies. 

That diversification smooths out the bumps of any individual company.

That’s why people say ‘diversification reduces risk’.

Shares vs property vs managed funds: which one is riskier?

So now we have all the basics covered, we can finally answer what’s riskier: shares, property or managed funds?

The answer is … it depends how you invest. 

Investing in a Balanced managed fund will typically be less risky than investing in a Growth fund. That’s because a growth fund has more shares than a balanced fund. 

And investing in an S+P tracker fund will be more risky than investing in a standard Growth fund. 

That’s because the S+P 500 is 100% made up of shares. A Growth fund will typically have a little more diversification.

Buying a property with no mortgage (all cash) is about as risky as investing in an S&P 500 tracker fund. 

And investing in a Blue Chip stock is a bit riskier still. 

Buying an individual property with a 50% mortgage is more risky than investing in Blue Chip stocks, but not as risky as investing in some growth stocks (in this case Apple). 

But the most risky investment in this sample is buying a property with a big mortgage (20% deposit). 

Your wealth in the property will fluctuate a lot. Now that doesn’t mean you should never invest in property. I’m really saying that you should understand the asset you’re buying. 

Leveraged property can supercharge your returns, but the road will be bumpy. That’s why at Opes Partners we often say to investors: plan to hold on to your property for at least 15 years. 

Does this mean never invest in property?

The whole point of this article is to get across that investing in property (especially a mortgage) is a high risk, high reward investment. 

Leverage isn’t a free lunch. It can provide massive upside, but it does have risks, especially if you need to sell in the short term.

And be aware that while property prices tend to go up … your wealth in a property can jump around a lot. 

Personally, I still invest in property, but I do it knowing that I need to hold on to it for the long term. That’s because month-to-month (and even year-to-year) my returns will be very up and down.