As financial planners, we’re continually speaking with our clients about the right investment strategies for them. A good financial plan is one that puts in place sound strategies that give you every opportunity of achieving your long term goals. The amount of risk that you’re prepared to accept can have a major outcome on your success in achieving your goals.
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.
Here’s a fact file that covers some of the basic investment concepts we’ll be talking about this week. Have a quick read of it to familiarise yourself with some of the terms we’ll be talking about.
Understanding risk and return
One of the fundamental concepts of investing is the idea of being rewarded for taking on a higher level of risk. We have another fact file that looks at this topic in more detail. Read it now by clicking on this link.
Generally speaking, investments that have the potential to provide high returns over the long term will fluctuate more in value over the short term. Some months (or years) they’re up, sometimes they’re down, but over the long term, on average, they produce strong returns.
You’re rewarded by accepting a higher degree of uncertainty in your returns over the short term by the likelihood of a stronger return over the long term.
At the other end of the spectrum, a nice safe investment that never declines in value (like a bank account) is unlikely to produce high returns over the long term. Because you accept the certainty in returns, you forgo the opportunity to obtain higher returns.
The old phrase is true – the higher the risk the higher the potential return.
Generally, investments like shares and property have the potential to produce the highest returns over the long term, but are also most likely to fluctuate in value over the short term. On average, we expect shares could produce a negative return once every 5-6 years.
Different types of 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 afford 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.
When we speak with clients, usually they equate risk with the loss of capital (more about this in future articles). In reality, one of the greatest risks you face is not having enough money to fund your future lifestyle expenses. For many clients, there is no option but to accept a moderate level of risk (fluctuation in returns) in order to gain the potential for stronger returns over the long term that enable them to achieve their goals.
How we manage risk
One of the best ways to manage risk is through the concept of diversification (more on this in tomorrow’s article).
We spend a lot of time speaking with clients about the risk and return trade-off. Using our financial planning software, we can model a range of different scenarios for you using different rates of returns for the different types of portfolios. This makes it easier for you to make an informed decision about the level of return you require to achieve your goals. With your desired level of return comes an expected level of risk. We’ll help you understand the implications of this. Remember, investing too conservatively could result in your goals becoming unachievable.
Because we know that investments like shares can be up and down in the short term, but produce strong returns in the long term, we’ll make sure your investments reflect the time frames you have. If you need capital in the next two or three years, we’ll generally suggest you move it to cash. If the markets drop just before you need your capital, your money in the cash investment is protected from the downturn.
Summary
Every investment has its own level of expected risk and return. It’s important to understand that you if you accept some short term fluctuations in capital (i.e. a higher level of risk) you should be rewarded with a higher return.
At times like this, it is tempting to sell your long term investments and invest them into investments that are only suitable for the short term like cash and fixed interest. We believe that over the long term, returns will revert back to averages. If you have long term money, it should remain invested in assets that will perform best over the long term.
Action steps
If you’re unsure about the level of risk you’re prepared to accept, or if you’re concerned about not having enough money for the future, please contact us. We can meet with you and help you better understand the choices that are available to you.
In tomorrow’s article we’ll look at the concept of diversification.
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