When deciding which investments are right for you, it is important to understand the trade off between risk and return and how to manage investment risk. A risk profile can help identify the type and mix of investments that will best help you achieve your financial and lifestyle goals.
What is risk?
Investors face many different kinds of risk. One of the most common is the variability of returns. If returns don’t meet expectations, investors may not be able to meet their goals or fund their ideal lifestyle.
All investments carry some risk due to factors such as inflation, taxation, an economic downturn or a drop in a particular market. Even if you choose an investment traditionally considered ‘safe’, such as cash, there is still a risk of inflation eroding the value of your capital or falling interest rates reducing the level of your return.
Understanding risk vs 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.
Risk and return
Managing investment 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 fluctuations in returns.
For example, if you are saving for a house deposit and have only 12 months to go before you reach your goal, you would probably be unwilling to risk losing any of that money. If so, it would make sense to avoid growth investments and consider defensive investments instead. However, if you’re investing your superannuation and you’re not retiring for 15 years, you could ride out any short term losses in growth markets to achieve potentially higher returns over time.
Calculating your tolerance for investment risk
When selecting your investments, along with considering your investment time frame it’s also important to reflect on your personal tolerance level for investment risk. You need to make sure you feel comfortable with the amount of risk you’re taking on and the potential consequences of your investment decisions.
Some people can remain relaxed while their account balance fluctuates, while others become nervous if their account shows even a small drop in value. If you’re going to lie awake at night worrying about your investments, no matter what returns you earn, they’re not likely to be worth the personal cost.
Several factors will affect your tolerance for investment risk:
•your reasons for investing
•your performance expectations
•how long you intend to invest (investment time frame)
•your knowledge of investment markets and past experiences
•how you feel about sudden increases and decreases in the value of your investments.
Keep in mind that your tolerance for investment risk may change as you gain investing experience and confidence.