Like my Grandfather used to say, “The higher the return, the higher the risk”. However many investors tend to focus on finding the investment with the highest return rather than appropriately weighing up risks. So what is risk?.
For investors, risk is the chance that an investment’s actual return will be different than expected. It could include the loss of some or all capital, a lower than expected rate of return, or a lower than expected income. Conversely, it could also include a higher than expected return, although most investors see this as ‘skilled’ investment selection. “In the investment world, the rear-view mirror is always clearer than the windshield.”
According to Modern Portfolio Theory, a strategy that carefully chooses different investments that work together in order to achieve a stated outcome, returns are relative to the amount of risk you are willing to take. Investors that are, in the short term, willing and able to accept variance in annual returns as well as variance in capital are able to gain higher returns in the long run.
So why doesn’t everyone just invest in investments with the highest volatility and therefore the highest return? The first reason is that not all investors can emotionally withstand higher volatility, to see capital move up or down by 10% can be quite distressing for some investors, especially retirees who rely on investment income to provide for living expenses. The second reason is practicality. For example, if the funds have been earmarked for a house purchase, security of capital is far more important than achieving a higher potential return.
There are a number of strategies investors can employ to reduce investment risk. One of the most common methods is Diversification. This means spreading investment capital across a range of investments as well as different asset classes including shares, property and interest type investments. My Grandfather referred to this as “not putting all your eggs in one basket”.
There are many resources available online which investors can utilise to help make investment decisions. The Government funded www.sorted.org.nz is a good place to start and includes a handy nine question quiz which helps determine how much volatility can be tolerated. The website also recommends researching, comparing and contrasting everything, which reminds me of one last piece of my Grandfathers advice; “If it’s too good to be true …”.
The views in this article are of a general nature only and should not be considered personalized advice. A disclosure statement is available and free of charge.