Risk and investments are inalienable; you cannot have the former without the latter. Simply put, risk is the chance that an investment decision fails to yield the expected return, resulting in capital loss. Whether an investment is high- or low-risk is usually determined by considering historical behaviours and outcomes and other variables. For instance, government bonds are considered low-risk because it is highly unlikely (but not impossible) that the government will default on its loan payments. On the other hand, real estate may be seen as high-risk because historically, the real estate market is unpredictable.
Investors need to understand risk because it guides how, when, and what they invest in. It also helps them balance the need to make a return and preserve their capital from loss. So, what crucial risk information do potential and present investors need so that they can make informed decisions? Let’s explore below:
Generally, higher risk investments have the potential for high returns. They also limit investors’ liability, have an easy buying and selling process, and earn capital gain plus dividends in some asset classes, e.g. stocks. However, they also come with an elevated chance of loss because there is no guarantee on your capital and the prices of the underlying investments may fluctuate based on factors beyond your control, such as economic recession, inflation, depreciation and government policy. Some investments that are considered high-risk include real estate, cryptocurrencies, venture capital, unregulated unit trust funds and high yield bonds, among others.
As the term suggests, low-risk investments have a lower chance of capital loss. They are generally considered safe, but investors must understand that they are not completely risk-free. The price to be paid for lower risk is a lower return. However, investors will enjoy assured returns and capital safety. Government bonds, fixed deposits and money market funds are examples of low-risk investments.
All investors need to understand their risk appetite. Your risk appetite is the amount of risk you are willing and able to incur for any given investment. Different individuals and institutions can bear varying levels of risk, depending on the return they want to make, income, investment horizon, age, financial priorities, among others. Older investors, for example, have a lower risk appetite because their priority is to preserve capital while younger ones want to grow their capital, hence have a much higher tolerance for risk.
When you understand how much risk you are willing and can afford to tolerate, you will make much sounder investment decisions, because you will be able to stomach large swings in the value of your investments and avoid panic actions. Speak to a financial advisor to help you figure out what your risk appetite is.
Because one cannot invest without risk, investors and fund managers need to manage it. Risk management strategy, which we’ll delve into further next week, is a long-term approach that seeks to minimize risk while maximizing the return. It ensures that investors get the best of both worlds and should be an important part of a good fund manager’s overall investment strategy. Some risk management techniques include portfolio diversification, rebalancing, position sizing and stop-loss orders.
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