Risk, reward in investing
IF I TOLD you that for a limited period I could offer you a guaranteed 15% return with no risk, would you take it?
Or if I put a coupon at the end of this article requesting your name, address and bank account, would you submit it?
Remember, there is no such investment. With investing, there are no free lunches.
If you want to receive maximum returns you have to take maximum risk but, conversely, the concept that the greater the risk, the greater the return, is a fallacy. It boils down to the risk: return ratio which is a fundamental investing principle.
The ratio can be interpreted as risk and reward, as in how much risk must you take to ensure you are aptly rewarded? Whenever you invest for growth there is risk, whether large or small.
With the new compliance regulations, financial advisors are compelled to record the advice given to a client and as part of the advisor's recommendations, a risk questionnaire needs to be completed which gives a corresponding score. Scores then determine the investor's risk profile.
On a scale between low and high risk, those who stick to the low risk are considered conservative investors. Those who favour high risk are considered aggressive investors, and a middle position would be moderately conservative or aggressive.
Conservative investors are happy with a low risk profile, particularly when markets are down and there's a lot of volatility because they feel their decision is justified. Regrettably, they rarely see these as great investment opportunities for the future and that their "comfort zone" will cost them dearly in the long term.
The same applies to aggressive investors who feel their decisions are justified when markets are moving forward and they are able to see the volatile times through.
There is no right or wrong position on the scale. Each individual's circumstances are different and with legislation and compliance governing financial planners, it is the responsibility of a financial advisor to understand, in consultation with the client, how much they need to accumulate for retirement and then assess whether their chosen risk profile is likely to provide what is needed. If not, this needs to be adjusted accordingly.
There are other criteria which determine an investor's risk return profile such as time-frame and their net worth. Time-frames determine that any investor who anticipates needing a large sum of money in the short term cannot consider taking any risk.
In my opinion, a 1-3 year time horizon is a "saving to spend" outlay, which cannot be viewed as investing for the long term.
Those with long-term time horizons can afford to wait and ride out price fluctuations and the longer the time-frame the more likelihood that if invested in quality, they'll reap the rewards.
How would you feel if you lost 25% of your capital in the next six months?
Few would be happy unless they fully understand the risk return ratio and the effects of this in achieving long-term investment growth.