Sunday, April 01, 2007

How Much Risk are You Willing to Take?

Series: Beginning Investing (9th post)
Section: Get Started

Hi everyone and thanks for your patience these last couple of months. I'm kind of settled now and hoping to be able to resume my normal posting schedule.

In today's post I'd like to discuss the risk-reward equation that forms the basis for all financial planning (and possibly of life itself, but that's the subject of a philosophical discussion). Essentially, the system is based on the premise that your rewards, or potential gains, are directly proportional to the amount of risk, or potential loss, you are willing to take.

What this means is that you tend to make less money from investments that are low-risk such as government bonds, savings accounts, time deposits etc. These investments are 'safe' and you are extremely unlikely to lose any money except in really extreme circumstances such as wars or suchlike, as a result of which the gains you make are rather low. Typical interest rates would be 3-6%, which is not even enough to beat inflation.

On the other hand, you have the potential to make windfall gains from more risky investments such as stocks and art, but there is a strong possibility you might lose money instead.

Risk in itself is not 'bad'. Because an investment is high-risk does not mean it is a poor investment. The element of risk is just something you should be aware of, comfortable with and able to manage.

Managing Risk and Asset Allocation

Risk can be managed through proper asset allocation i.e. spreading your savings over a number of different investment vehicles (or asset classes) so as to reduce your dependence on any particular one. This allows you the flexibility to settle on a mix of investments that have a risk-reward profile that you are most comfortable with. This would be a weighted average of the different asset classes you select and the way you distribute your money between them.

You should do your asset allocation based on your personal inclination (e.g. some of us are inherently more risk averse and conservative than others), stage in life (e.g. someone nearing retirement would typically be more conservative than someone in his early thirties) and financial commitments (e.g. you would want your basic living expenses to be coming from a secure and dependable source such as a savings account). Ideally try to get help from a qualified financial planner who would be able to take you through a series of questions in order to identify the best risk profile and asset allocation for you.

Rough Guide to Risk-Reward for Different Investments

As a rough guide, here are the kind of returns you could expect from different forms of investment. The classifications are mine, I don't think there is any standard form of classification used generally:

  • Low Risk (very low probability of losing money) e.g. savings accounts, government bonds, time deposits, gold): 3-6%
  • Medium Risk (some chance of losing money, especially when buying in an overheated market) e.g. real estate, gold: 6-10% long term
  • High Risk (significant chance of losing money, markets volatile) e.g. mutual funds, REITs: 10-15%
  • Very High Risk (strong chance of losing money, markets highly volatile) e.g. sector-focused equity funds, individual stock picks, forex, art, hedge funds: 15-30%

The above might seem a little on the low side, especially given the kind of returns we have seen in the real estate and stock markets, but I believe these should hold for the long term.

Your personal portfolio returns will be an average of the returns above, based on your asset allocation.

Next Post on Beginning Investing: Asset Allocation and Investment Maturity