As an investor, we need to think about risk and returns. Some investors just focus on maximising returns without thinking about the risk taken to achieve those returns. Others are so worried about losing money that they completely avoid risk altogether.
It is important to understand that risk and return (or reward) come hand-in-hand - the more risk you take, the higher the return you should receive. This is the risk/reward trade off.
How do you feel about risk?
Do you like to take chances, or are you conservative by nature? You may think you have a high tolerance for risk but it can boil down to one simple question - how would you feel if you lose some of the money you have invested? It is important to consider the answer to this question because your attitude to risk can and should influence your choice of investments.
There are different types of risk and many change over time or have different implications depending on:
- your time horizon
- your attitude towards volatility
- your stage in life.
Not all risk is bad
All investments involve risk and taking on the 'right' amount of risk is essential to increase your capital over time. It is also important to look at the type of risk you are taking and avoid investments where you won't be rewarded with higher potential returns. The avoidance of risk altogether or being too conservative can be the greatest risk of all as it significantly reduces your potential to increase your wealth over time. The key is to consider how much risk you are comfortable with and to invest accordingly.
Risk changes with time
The amount of investment risk you take may change significantly depending on how long you are going to hold that investment. But not everyone has the luxury of time, so it is vital to consider for how many years you are investing and identify investments which have the appropriate level of risk for you at this point in time. An investor with longer-term goals may be prepared to invest in higher risk growth assets like international shares. Achieving goals over the long term means there is more time to recover from potential losses along the way. Investors with shorter-term goals may be less wiling to invest in higher risk assets.
You are the most important factor when it comes to investment risk. Your stage of life and therefore your investment timeframe is vital to determine what type of risk you should take. To reiterate, while a sharemarket investment is a relatively low risk investment for someone in their 20s, the same investment might be very risky for someone counting on the money when they are very close to retirement. However, with life expectancies rising, it may still pay for some older investors to hold at least part of their portfolio in growth assets like shares so that they managed the very real problem of longevity risk - the risk that their money runs out before they do.
Often the sharemarket is considered to more 'risky' than, say, an investment in property. However, there are hidden risks with property. Over the very long term, both types of assets have provided a similar annualised return, however there is a great deal of liquidity risk with property. Shares might be considered less risky as they are easy to sell if you need cash. If you need to sell a property, which is an illiquid asset, and you need to sell it quickly, you may have to significantly reduce the price you are asking to attract a buyer.
Learn more about other types of risks.