Understanding the Risk & Reward Relationship

The aim of most investors is to invest in assets that will generally provide the best returns for their money within the level of risk they are comfortable with. To enjoy higher returns, you may need to invest in assets where there is greater short-term risk. So when it comes to your investments, rather than shy away from risk, consider it as just another factor that needs to be carefully managed.

What is risk? 
Most investors think of risk as the “chance of loss” or to quantify it, how much you could potentially lose for the potential gain. The basic rule of thumb in investing is the higher the risk, the higher the potential return; the lower the risk, generally the lower the return. There are also other risks associated with investing. These include risks such as investments that don’t keep pace with inflation, or investments that experience unacceptable levels of volatility (fluctuations in value).

Managing risk

There are a number of steps you can take to better understand and manage the risks associated with investing: 
Clarify your “risk profile” 
It’s important to understand how much risk you are willing to take with your investments. Are you happy with low growth investments that provide returns marginally above inflation for very low risk, or are you prepared to take more risk with your investments for potentially significantly higher returns? All of us have a different appetite for risk, so you need to know what level you are comfortable with before making your decision.

Set your investment objectives 
Secondly, work out how much of a return will make you happy and meet your needs. What are your future goals and what kind of investments can help you achieve these goals? For example, are you saving for your retirement or a round the world holiday?

Know your timeframe 
The amount of time you have available to invest is also critical in determining which investments may suit your needs and in managing investment risks. The longer you have to invest, generally the more risks you can take with your investments, as there is more time for you to ride out the peaks and troughs of investment performance. Alternatively, investors nearing retirement may wish to invest in low risk investments where the likelihood off fluctuation in investment performance is significantly reduced.

Diversify your investments 
Diversifying your investments across a range of assets and asset classes can also be an effective strategy in helping to reduce investment risk. By spreading your investments around, you aren’t as affected by (or “exposed to”) the movements of just one market, some of which may rise, while others may fall.

What should I invest in? 
Asset classes have a long history and have been the focus of much analysis. Although it is difficult to pick exactly how well one particular asset is going to perform, as a general rule of thumb, the lower the risk, the lower the return and the higher the risk, the higher the potential return. When choosing what asset class to invest in, the three major classes of financial assets in order of their volatility from lowest to 
highest are as follows:

• Cash / Certificate of Deposit 
• Bonds 
• Equity shares

Choosing which asset class to invest your money will depend on many factors including your risk profile, the amount of time you have to invest and your overall investment objectives.

Mutual funds 
Mutual funds are designed to give investors access to a range of investments they would find difficult to access on their own. There are many mutual funds available and they usually provide a diversified approach to investing, ensuring an appropriate balance of investments and asset classes to minimise risk. Different mutual fund schemes have different levels of risk, depending on the way they are weighted across the various assets. For example:

• Fixed Income schemes are heavily weighted in fixed interest and cash investments. These are generally low risk in nature and provide lower returns. 
• Balanced/growth schemes generally have a heavier weightage in equity than in Fixed Income instruments and aim to provide higher returns than a Fixed Income schemes. 
• Equity mutual fund schemes are high growth schemes will have an even higher weighting in equites. They carry the greatest risk, but over time, may provide the highest returns. There are also mutual fund schemes that comprise a single asset class (eg. Technology funds). As these funds invest in one asset class they can potentially involve a greater level of risk, but may also generate higher returns over the long term.

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