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Investment Strategy: Risk vs Return

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Investment Strategy: Risk vs Return

  • Risk refers to the likelihood that the actual returns of your investment will be less than the expected returns. 
  • On the other hand, return on investment is the profit you gain from the initial investment, which could include income and capital gains, often expressed as a percentage.
     
  • Market volatility and downturns which can affect asset prices can influence risk, just as inflation and weak business fundamentals. 
     
  • Both the risks and potential returns largely depend on the type of assets you have chosen to invest in. For instance, stocks offer growth but they are volatile, whereas bonds are less risky but their returns are also lower. 
     
  • Risk and return are highly related. In fact, high potential returns on investment often go hand-in-hand with increased risk and in contrast, lower risk investments provide a lower long-term return.
     
  • Your investment time frame, in other words the period where you are expected to hold an investment for a specific goal and having a diversified portfolio are two great ways of managing your risk. 
  • As you determine your investment strategy, you must also keep in mind the growth rate at which your money may increase during the time it is invested. Depending on your current situation and your future goals, the yield – the interest or dividends paid on your investment is also important. Lastly, consider your risk tolerance.
     
  • Striking the right balance between risk and return is easier said than done. This is why you should consider getting a helping hand from one of our professional advisors.

 

Investing can help you build the appropriate foundation for the life you want to create for yourself. But with returns comes also risk, be it due to inflation, economic downturns or drops in particular markets and this can result in you losing money or not making as much as you were expecting. Strategic investing involves evaluating your investment goals, assessing how much money you can invest and becoming better acquainted with your investment choices and the different levels of risk and returns each carry so that you can allocate your funds in a variety of ways and get the best return possible.

Here we delve deeper into what risk and return are, as well as their intrinsic relationship.

 

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What is risk and what is return?

In general terms, risk refers to the likelihood that the actual returns will be less than the expected returns. This can take place if the value of an asset which you have invested increases at a lower than expected rate or decreases when you were expecting growth. However, there are other risk factors, such as the risk of losing your initial investment, which could occur if for instance you have invested in a company which eventually goes bankrupt and as a result you lose your total investment. There is also the risk of receiving a lower than expected income return if you purchased shares and the dividend payout was less to that you were hoping for.

Factors that could influence risk include market volatility and downturns which can affect asset prices even if the fundamentals remain sound. Another fact is inflation which leads to a loss of purchasing power and higher expenses, while it can result in lower profits for companies. What’s more, if you have invested in specific companies, you may be at risk of weak business fundamentals which could lead to declining profits and losses and even default on debt obligations.

In contrast, return on investment is the profit you gain from the initial investment. Profit includes income and capital gains and it is expressed as a percentage. Actual results and estimated return are often used to evaluate various assets, as well as different securities within each asset category. By doing so you have better chances of picking the right mix of securities and to maximise returns. And just like risk, a number of factors can influence the type of returns you can expect from your investment.

The risks you are exposed to, as well as the potential returns largely depend on the type of assets you have chosen to invest. Shares, also known as stocks or equities offer growth, but they can be volatile. On the other hand, bonds provide a steady income and can also offer some growth although they come with varying risks which are usually proportionate to the returns. Collective investment schemes like funds offer growth, income or both, but are also subject to volatility in the value of the underlying investments and have lower potential earnings.

 

What is the relationship between risk and return?

The ideal investment which is of low risk yet offers high returns does not exist and in effect, when it comes to investing, risk and return are highly related. High potential returns on investment often go hand-in-hand with increased risk, whilst in contrast, lower risk investments may offer peace of mind, yet they also provide a lower long-term return.

 

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How can you manage investment risk?

Before delving deeper into how to manage investment risk, you should first gauge your risk tolerance, in other words, how much risk you are willing to take on. This will depend on your situation, while your risk tolerance will ultimately determine the type of investments you should hold in your portfolio. Have you been saving for retirement and you are just a couple of years away from reaching your goal? Then having a mix of conservative investments would be ideal in this case since you can protect the bulk of your money.

Once you have estimated your risk tolerance, there are various ways you can manage risk.

Investment time frame
Your investment time frame will have a significant impact on the investment decisions you make and as a consequence, the level of risk you can undertake. The longer you stay invested, the less risk you are exposed to since you will have sufficient time ahead for any fluctuations in the value of your investments to even out over time. Your age and how close you are to your retirement will determine whether you are investing for the short, medium or long-term and as expected, life events will require adjustments to both your financial plan and portfolio.

Diversification
An investment portfolio is the collection of all your investments – all the shares, bonds, cash deposits, property and so forth. Careful investing involves building a diverse portfolio, one in which your investments are spread over a range of investment choices. Doing so is crucial since there is no certainty as to how your money will grow over time, so diversification can help protect you when some investments do not perform as well as others. Irrespective of what your portfolio will hold, remember that its composition should align with your financial objectives and your financial plan. Have a look at why having a financial plan is crucial to your investment success, while here is further information on diversification.

 

The risk and return profile of different asset classes

Bearing in mind that diversification is key to offsetting risk and making the most of your returns, you should always ensure that your portfolio is adequately diversified. There are several steps you can take to do so and here are a few examples.

Investing in collective investment schemes allows you to diversify within a class of investments such as shares or bonds without actively designating where the money should go among these individual investments. Once you make a lump sum investment in a collective investment scheme, a fund manager takes care of spreading that sum among a range of investment options. In exchange for their services, these schemes generally charge you a fee based on the amount of your yearly assets in the fund.

Individual investors, especially those with long-term investing plans who are willing to absorb market shocks may feel confident investing a portion of their money in shares. Within the world of shares, there are many ways to diversify as well. For example, you can invest in:

  • Blue chip shares – these are large, established companies with strong records of profit growth that often pay dividends.
  • Growth shares – these are companies that are just starting out. These type of companies whose earnings are increasing at a rate faster than the industry average are often smaller companies today but may grow in due time.
  • You can also diversify your investments by purchasing shares in a variety of industries. In this way, when one industry is declining, another may be growing.

After examining the various options available, you must then decide what percentage of your income you want to invest where. Like other components of an investment plan, your need for a diverse portfolio may change over time.

The chart below shows the risk return profiles of each of the different asset classes.

 

Security Type Financial Risk Protection against inflation Liquidity (how easily investments can be converted into cash)
Bank Accounts
Savings Low None High
Fixed Deposit Low – but subject to a penalty if withdrawn prior to the full term of deposit None Moderate to low
Shares Medium to High Good High
Bonds
Government Low to Medium Fair Varies, but generally high
Corporate High Quality Low to Medium Fair
High Yield Medium Good
Funds investing in:
Shares, Bonds Low to High – Depends on skill of fund manager and objectives Good High (with exceptions in respect of closed-ended funds)
Money Markets Low risk None High
Real Estate
Home, Commercial Property Medium to High Good Low
Collectibles
Art, antiques, gold, etc. Medium to High Varies Low to moderate

Bonus tips:

As you determine your investment strategy, here are some points to keep in mind:

Growth

Growth is the rate at which your money increases in value during the time it is invested. If you think you will need your money back sooner rather than later, look for an investment that provides a fairly safe, steady growth rate and which is relatively liquid. High growth investments might be tempting but are usually subject to substantial fluctuations. Long-term investments that are influenced by factors such as the inflation rate may lose money in the short term, but they can still grow over an extended time frame.

Yield

Yield is the interest or dividends paid on your investment. Like growth, it can vary in importance depending on your needs. If you are retired and your investment is funding your retirement, this should generate enough yield to let you live on the interest. Savings or fixed deposit accounts tend to yield small percentages, bonds, on the other hand can yield higher percentages, but their yield rate is affected by inflation. Equities and collective investment schemes which invest in equities can yield the highest percentages but also have the greatest chance of loss.

Income

Closely related to yield, the third factor to consider is income. Does your investment or the yield from your investment make up a significant portion of your income? If so, you may want to be more conservative with your investment choices to ensure that the amount of yield it produces remains consistent and reliable. You should give careful consideration where and how often you want to reinvest your money as it could affect your financial security. If you are retired, your investments may be your primary source of income and it is generally more important that you select investments that produce income rather than growth.

Risk

Every investor has a different risk tolerance. If you are a conservative one, you should probably seek opportunities that offer safety and some measure of control over your return. Conservative investors may choose to miss some high-growth opportunities by keeping their money in investments with more secure rates of return. On the other hand, aggressive investors will take their chances with a volatile or fluctuating market since they may have the opportunity to receive a greater return on their initial investment. For investors who fall between the two, they could choose to invest partially in conservative outlets, while invest other funds in riskier ventures.

 

Once you have determined your risk tolerance and your expected return, the investments you ultimately select must match. Yet, striking the right balance between risk and return is easier said than done. This is why getting a helping hand from a professional advisor is important. CC’s financial advisors can draft your financial plan, while by having direct access to the markets they can help you select the optimal investments. Have a look at our full range of investment options.