- Date : 06/10/2020
- Read: 5 mins
Understanding the relationship between risks and rewards before investing is crucial to create an asset portfolio that minimises risk while maximising your returns.
While putting your hard-earned money on the line, it is important that you recognise the risks associated with various investments. A thorough knowledge will help you in developing and maintaining an efficient long-term investment strategy that can amplify your savings.
It is commonly stated that risk and reward are two sides of the same coin. Higher the risk, higher the reward. What this actually implies is: higher the risk, higher the potential for reward.
The first step is to define your investment goals and risk tolerance. Risk tolerance is the level of uncertainty you’re willing to accept for a higher potential return. Now, it’s obvious that no two people will have the same appetite for risk. A combination of factors such as income, time horizon, expected rate of return, age and retirement plans, other financial resources, etc. determine a person’s risk tolerance.
Once you realise where you fall on the risk-reward spectrum, you will be better placed to formulate an appropriate investment plan and structure a portfolio that satisfies your objectives.
Scouting for investment instruments can be overwhelming. Should you put your money in the stock market? Or play safe and stick with bonds? Or should you go the mutual funds route? Since each instrument has its own unique risk profile, you should weigh the risk against the potential reward before you invest.
Let’s consider some risks that every investor must be aware of:
- Losing your principal – The risk of losing all the money you invested is a legitimate concern. The risk of losing your principal is especially high in case of equities. In the event the company goes under, you might be unable to recover the money you paid for its shares. You can mitigate this risk by making investments in government-backed securities that guarantee the safety of your principal amount. However, you will have to compromise by earning a very low return.
- Inflation risk – This is the risk that your investment income will not be able to keep pace with the rising cost of living, thereby reducing purchasing power. It erodes returns of fixed return instruments like bonds, cash, and cash equivalents such as savings bank accounts. Shares offer some protection against inflation because most companies can increase the prices they charge their customers. Real estate can provide a hedge against inflation.
- Liquidity risk – The chance that you won’t be able to sell your investment at a fair price and convert it to cash when you are in need of money is called liquidity risk. Real estate might do well when it comes to inflation but it also carries one of the highest liquidity risks.
- Inadequate returns – The possibility of not meeting your expected quantum of returns is another common risk. For instance, your earnings might not be enough to cover your post-retirement needs.
- Volatility risk – Frequent unpredictable fluctuations in the market price of a particular asset can be unnerving for some investors.
Next, let’s evaluate the risk profiles associated with some popular investments:
- Stocks – Stocks tend to offer a comparatively higher rate of return than other instruments. However, equity shareholders risk losing their money as they have the last claim in case the company runs into financial difficulties. Blue-chip companies, although expensive, have a relatively stable stock price, pay dividends regularly, and are considered relatively safe. Alternatively, smaller companies such as penny stock firms or start-ups can offer more volatile returns.
- Bonds – If you are looking to offset some risk from a stock-heavy portfolio, bonds are a safe bet. The credit score assigned to them by rating agencies will help you gauge their level of risk. For example, AAA-rated bonds are the safest as they have the lowest default risk. On the other hand, lower rated bonds (investment grade and junk bonds) promise higher returns but come with a much higher risk.
- Mutual funds – Mutual funds are managed by professional portfolio managers and experts, making them highly attractive. Inexperienced investors can benefit from the expertise of fund managers. Mutual funds comprise a diverse category of assets with different risk profiles – from large company stocks to a mix of large and small stocks, to bonds and precious metals like gold, to foreign company stocks. They are a great hedge instrument, but high fees and maintenance costs can eat into your potential returns.
While there is no correct amount or type of risk, being cognisant and diversifying your portfolio with the right blend of investments will safeguard your money from market downturns and earn you high returns in a bullish market. If you want to learn how to invest in stocks like a pro, then this piece just for you.
Disclaimer: This article is intended for general information purposes only and should not be construed as investment or tax or legal advice. You should separately obtain independent advice when making decisions in these areas.