Risk versus return

When it comes to investing there are two main factors to consider:

• the risk you are prepared to take, and
• the return you are willing to accept.

Risk is the likelihood that your investment will fluctuate in value and the earnings may be less than you expect, possibly even negative. Return is the rate by which your investment changes.

Risk and return go hand in hand and the relationship between them is something you need to consider. Over the longer term, higher returns are usually associated with higher risk.

There are several ways to manage risk:

Spreading risk

Diversification or 'not putting all your eggs in one basket' is one way to manage risk and potentially increase returns.

Financial markets do not normally move in the same cycles. For example, while the Australian share market may be losing value, the bond market may be providing a relatively high rate of return.

By diversifying your investments, and holding a mix of assets, your risk is reduced because your investment is spread across a number of asset classes.

It's time in the market, not timing the market

Many investors try to 'time' their investments by buying 'low' and selling 'high' but determining the right time to buy and sell requires as much good luck as good judgement.

More often than not, 'market timers' sell when a market is low and are caught out of the market when the inevitable rally occurs.

The greatest risk is not the risk of investing in a declining market, but the risk of being out of the market at the trough of a decline when sentiment is at its lowest and the potential future returns are at their highest.

A far more sensible strategy is to diversify your investments across a range of asset classes and not panic if one particular market falls. And remember, when a market falls, it can be a good time to invest.

Set a time horizon

Your time horizon is extremely important in determining an appropriate investment strategy. Your age, your personal circumstances and the time when you require access to your funds are the fundamental issues to consider when setting an investment time horizon.

If you do not require the funds for a long period of time, and in order to maximise your returns, you may be willing to accept some fluctuations in the value of your investment. The longer your time horizon, the more potential there is for higher returns because you have more time to ride out the ups and downs of the market.

Determine your risk tolerance

Your risk tolerance is your willingness to accept fluctuations in the value of your investments. A low risk investment may have little risk of capital loss, but it may also have a lower rate of return.

If you invest in a conservative manner, you need to also be aware of inflation risk, that is, the risk that your investment returns may not exceed the rate of inflation.

A more aggressive investment (or growth investment) on the other hand, may provide you with a much higher level of volatility, but has the potential for higher returns. The longer the time horizon, the more time a growth investment will have to recover if it happens to take a down turn.

In between the conservative and aggressive investments are the balanced investments which aim to offer a comfortable balance between risk and return. A balanced investment is not necessarily a better choice than either of the two options above, it really depends on your individual circumstances.

Handling volatility

It's important to understand the concept of risk and return, otherwise it's easy for you to choose the wrong investment strategy, for example panicking in a negative market and losing sight of your long term goals.

Most of us will feel uncomfortable in a negative market because we fear a drop in our investments. But negative periods in markets are a normal part of the investment cycle. Until your investment has been sold the decrease in value is simply a 'paper loss' or a loss which has not been realised.

History shows us that markets recover, however, this recovery can take time. The important factors to consider in volatile markets are:

• don't panic if your investments go down in value. Stick to your longer term investment strategy
• when creating your investment portfolio, diversify your investments to protect yourself from risk.
• match your objectives with realistic time frames.

If you have any further queries about risk or return or the relationship between them, we recommend you speak to a Wealth Managers financial adviser.

Wealth Managers Pty Ltd (Wealth Managers), AFSL No. 232701.
Part of Australian Wealth Management
This article has been provided as a general guide only and does not take into account your individual circumstances. Wealth Managers, its directors, employees or any associate are not liable for any loss or damage arising as a result of any reliance placed on the contents of this article. You should consider contacting your financial adviser before making any financial decisions.