--Investment strategy-- In fact, there is an inherent link between investment risk and investment reward, or return. That is, the higher the expected return of a financial asset or security, generally, the higher the risk associated with it. But what is meant by ‘risk’, and how can we manage the risks associated with investing? Even the perceived safe haven of cash has risk attached to it. There’s the risk that the bank it is held with experiences some sort of problem or failure. The 2008 global financial crisis, when very large international banks such as Bear Stearns and Lehman Brothers crashed and burned, is a recent example. What investors are really saying when they say, “I want the highest return I can get, with the lowest risk”, is that they want the best return they can get. Of course this will be based on the amount of risk they are willing to take. Essentially every investor has two key objectives they want to achieve: 1. to protect and/or grow their capital 2. to get a return better than what they can get in a bank deposit. Most importantly, investors don’t want to be worried that they might lose a significant portion or, worse, all of their hard-earned nest egg. They want to be able to sleep at night. So how might an investor achieve the ultimate goal of getting a good return, at an appropriate level of risk, but one which also allows them to sleep at night? Before we answer this question, there are two simple concepts to consider. The first is the concept of risk, what it means and how it affects investment returns. The second is diversification and how it can be used to manage risk and assist in generating better returns for investors. Everybody is familiar with the concept of risk. We face risks every day as we go about our lives. Essentially risk has two components: exposure and uncertainty. Every time we hop in our car to drive somewhere there is risk involved: we are exposed to the danger that we may have some sort of accident, even though the chances of being involved in an accident are uncertain as we don’t know what actions other drivers may take or what set of circumstances may place us in danger. But this risk does not stop us from driving. Instead, we assess the risk and we take precautions like wearing a seat belt, obeying the road rules, and being alert to other road users – and most of the time we arrive safely at our destination. Investment risk is no different. Whenever we invest, we are exposed to uncertainty, but this time the uncertainty is that the investment will not turn out as expected. While this could go one of two ways, i.e. either better than expected or worse, it is the latter that investors want to avoid. The variation of returns for any given security, asset or group of assets is referred to as volatility. Volatility is a measure of the degree of up-and down movement in the value of a security or asset over time. Volatility is a common measure of risk in the investment world. Principally, low-risk assets have low volatility and high-risk assets have high volatility. Investments in cash and bonds tend to be less risky than property and shares. If you’re older, you are more likely to be more cautious in your approach in comparison to someone with many years of earning potential ahead of them. And don’t be put off by risk. Properly managed, risk is good, investors can benefit from taking risk. That is what ultimately drives investment returns. -Diversification Diversification is a simple concept. To use a sporting analogy, think of a golfer and how difficult it might be for them to play a round of golf with just one golf club, say a putter. They’ll have no trouble on the greens when it comes to sinking the ball in the hole, but getting there from the tee will be a real struggle. This issue is rectified by playing with a fully diversified selection of clubs – from a driver for teeing off, to a set of woods for longer fairway shots, a full set of irons, wedges for short play, and finally the putter. The same applies to an investment portfolio. Investors require a ‘full set of clubs’ to achieve their investment goals, but this time the ‘clubs’ are the various financial assets across the universe of available assets (shares, property, bonds and cash). The mixture of those assets in any given investor’s portfolio will vary depending on the investor’s objectives, goals, time horizon and tolerance for risk. Traditionally, asset classes are grouped in two categories: 1. Income assets generate a high portion of their returns from income via interest or coupon payments, e.g. cash and bonds. 2. Growth assets generate a high portion of their returns from capital growth over time, e.g. shares and property. It is the potential of their capital value to match or exceed the rate of inflation that makes them considered growth assets. -So why diversify? A well-known phrase talking about diversification is: “Don’t put all your eggs in one basket”. This is very apt. In investment terms, the concept of diversification is exactly the same. Diversification reduces both the upside and downside potential and allows for more consistent performance under a wide range of economic conditions. -How do I diversify my risk and for what benefit? In the main, most investors are going to diversify their portfolio across the ‘core’ asset classes of cash, bonds, property and shares. But how does an investor determine the appropriate mix of these assets in order to construct the optimal portfolio for their individual circumstances? This is where good financial advice comes in. Quality financial planning organisations provide a series of well-diversified portfolios which span the risk spectrum for investors. From conservative through to high-growth options, all the bases will be covered. **This article contains information of a general nature only. If you would like advice that takes into account your particular financial situation or goals, please contact your financial adviser. **
Posted on: Mon, 11 Nov 2013 01:07:19 +0000
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