17
May
2016

Risk v Return

the greater the opportunity for growth, the greater the risk

Watching the US Masters last weekend I heard the commentators discuss at length the old age risk v return trade-off, with the Augusta back nine famous for offering enticing opportunities for those brave enough to take on the added risk.  Many times we see the brave take the course on, with the great shot rewarded, but as we know, many also find disaster.

The same is true with investing, in general terms, the greater the opportunity for growth, the greater the risk. Growth investments such as shares and property have the potential for higher returns, but of course are more volatile than defensive safe-havens of cash and fixed interest.

So the question is how much risk am I prepared to take in order to achieve growth? This is very much decided on a case by case basis.

Financial Planners as a whole are at the conservative end of the investment advice spectrum, the financial planning industry is based around controlling risk and providing long term investment advice with high levels of diversification. Our most aggressive portfolios are more conservative than a lot people are already invested.

There are 3 broad factors that determine the investment profile that is appropriate. The length of time of the investment, the needs of the investment and the client’s natural aversion to risk.

In simple terms the longer the investment, the more opportunity for investment risk. The logic is simple, the longer the investment horizon, the closer the return will be to the long term average. A number of both good and bad years will be included and statically speaking over time the return will trend towards the long term average.  With short investment horizons, it more appropriate for safer options, if in the first or second year a negative year comes along (and they will come along), there is not a long enough time frame to “make up” for the bad year.

The requirements of the investment also play a large role in how much risk is required. Going back to the golf analogy earlier, if you are in front with a few holes to play at the Masters, it makes no sense to take extra risk, playing it safe seems like the logical option, the reverse is true, if you need to make up a few shots, taking on the risk in the hope of being rewarded makes more sense.

It is the same for investments, if you are investing a lump sum to provide income in retirement and are able to meet your goals investing in defensive assets, then it is unnecessary to take on additional risk. Conversely if you have limited assets compared to your needs, than investing more aggressively needs to be considered.

The needs of the investment in relation to how it is invested are actually reasonably complicated and other issues play a role in the risk reward trade off.

The last factor is the clients natural risk aversion. All of us are comfortable with differing levels of risk in all aspects of life; when it comes to investing the skill is quantifying the level of volatility a client will endure and still maintain the long term strategy. It is easy for people to get sucked into the greed/fear cycle and this normally leads to below average results.

 

The real secret in the whole risk and reward trade-off is once you have selected your balance, stay with it unless your circumstances change.

Author; Alex McKenzie Categories: Future Financial Services Blog

About the Author

Alex McKenzie

Alex McKenzie

Owner at Future Financial Services

Past:

  • Paraplanner at Zammit Partners Investments
  • Unit Trust Administrator at Colonial First State

Education

  • University of Western Sydney
  • Penrith High

About

As a Financial Planner I help people to achieve what they would like in life. This involves helping you to identify the things in life they would like , developing plans to help achieve them and strategies to protect what you already have. We do this by providing Financial Advice to guide you through your life stages.

The financial planning process involves determining a clients current situation and financial objectives and tailoring strategies to assist in best achieving those objectives.

I am an expert in superannuation, investments and insurance, these are tools we use to help you achieve your goals.

I aim to use my knowledge of superannuation, taxation and Centrelink to efficiently use your assets and income to achieve your financial goals.

Retirement and pre-retirement planning, wealth creation, asset protection, insurance planning and estate planning are all areas of advice that I provide.

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