- 19th Jun 2014
Understanding risk #Investment principle 4
There’s no such thing as a free lunch
The best way to look at investment options is through the lens of risk and reward. It is often said that the greater the risk, the greater the potential return on investment, but you should avoid taking on unnecessary risk.
Don’t put all your eggs in one basket
It is generally accepted amongst ‘investment academics’ that asset allocation has the biggest impact on return on investment within a portfolio. But, what does that actually mean?
Asset classes are types of investments such as cash, bonds, shares and property which have historically behaved differently; put simply when one asset class is going down in value another may be going up or simply not going down as much.
Identifying and fixing the right mix of these assets based on how much risk you are prepared to take is a strategy based on Modern Portfolio Theory; pioneering work that saw Harry Markowitz (an investment academic) win a Nobel Prize in 1990.
It therefore makes sense to protect yourself against risk by spreading money among various investments, hoping that if one investment loses money, the other investments will more than make up for those losses. This strategy, called “diversification,” can be neatly summed up as “Don’t put all your eggs in one basket.”
If you tolerate this……
Your personal tolerance for accepting investment risks should be the starting point in any sensible conversation about how best to invest your money. Your tolerance is a result of your experiences, attitudes and motivations to money. It is largely consistent over time but can be influenced by what is going on around you, such as sudden market losses or gains.
The key is to try and understand what you are expecting from your portfolio over the longer term so that the impact of short-term emotional responses can be limited. You could create the most carefully selected and diversified portfolio possible but if you are not prepared for the likely gains and losses that can occur in any one or two year period then you will not be able to live easily with it. Consider your stress levels, and don’t take on more than you can comfortably cope with.
Only risk what you need and can afford to
Whilst you might be willing to take a certain level of risk you need to not only ensure that you can actually afford to do so but that you actually need to in the first place.
It may not actually make sense for an investor with a high tolerance for risk to take much investment risk if the assets they have already accumulated can easily meet their requirements.
Crucially, though investments have an ability to constantly surprise and behave in a way that no academic research or investment guru could predict. Consequently, it never makes sense to invest more than you can afford to and that means ensuring that you always have sufficient short-term savings to fall back on in emergencies – essentially not overcommitting yourself.
Choosing the right diversification strategy and the best investments for you comes down to matching your emotional tolerance with your financial need to take risk and your capacity to suffer losses. Once you’ve done that, you can consider spreading your money across not only many companies and countries but different types of investments too
Past performance is not an indication of future returns. The value of investments and any income from them is not guaranteed and can go down as well as up. If you have any questions about the suitability of an investment, you should seek financial advice.