If you’re just starting out as an investor, there’s a lot of information to absorb. In this series of articles we will define and explore the fundamentals of investing.
#3. Risk vs Return
All investments provide a certain level of return and are subject to a certain level of risk. This means that as well as making money on your investments, there’s also the chance you could lose money or not make as much as you expected. All investments carry some risk – due to factors such as inflation, taxation, economic downturns or a drop in a particular market.
As a general rule, the larger the potential investment return, the higher the investment risk and the longer you need to remain invested to reduce that risk. The amount of risk involved with an investment can be managed by matching it appropriately with the length of time you have available to invest and your tolerance towards volatility or fluctuations in returns.
Understanding Risk and Return
The level of risk an investor takes relative to the investment return they expect to receive is sometimes known as the ‘risk to return ratio’.
As a general rule, the larger the potential investment return, the higher the investment risk and the longer you need to remain invested to reduce that risk. See the chart below for more detailed information on each asset class.
Chart: The attributes of each asset class
Managing Investment Risk
If you invest in just one asset class and its value falls, the value of your investment will drop with it. However, by investing in several asset classes, you spread your risk and can offset underperformance in
one asset class with positive performance in another. This could help you achieve smoother, more consistent returns over time. Each asset class has its good and bad times, so while a diversified portfolio will never achieve the top return in any given year, it will never receive the lowest either. The table below shows annual returns for the different asset classes from 1995 to 2014. As you can see, the top performing asset class one year may deliver the poorest results the next. This highlights the importance of diversification as a method of managing risk.
Table: Asset class returns
Investment Fundamentals #4: Developing Your Investment Strategy
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