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Understanding The Risk-Return Trade-off In Investments

The thought of savings should come to our mind since the day we start earning. Directing our savings to appropriate investment to generate added return is certainly a best bet for working towards that financial goal.
23 Feb 2019 17:59
Understanding The Risk-Return Trade-off In Investments
Investing

Each one of us have financial goals in life and these goals may vary from person to person.

Savings

Some of us may be planning to a go on a much desired vacation, send the children to school, buy a house, or simply retire with enough money to sustain a normal livelihood.

All of this may seem far-fetched, but with proper planning and by directing our earnings or savings in the right direction, the financial goals may be much easier to achieve.

The thought of savings should come to our mind since the day we start earning.

Directing our savings to appropriate investment to generate added return is certainly a best bet for working towards that financial goal.

Understand the basics of investment

However, one may need to understand the basics of investment and associated risks, to be able to better determine how much one can afford to invest and how to decide on a suitable investment instrument.

Understanding risk is an important part of any investment decisions we make.

Risk in financial term implies the probability that an actual return on an investment will be lower than the expected return.

It entails the uncertainty that an investor is willing to take to realize a gain from an investment.

What is risks?

Practically, risk means you have the possibility of losing some or even all of your original investment.

Risks are of different types and stem from different situations.

Examples of risks include economic risk, liquidity risk, sovereign risk, interest risk, business risk, default risk and so forth.

Returns

Returns on the other hand, is the gains or losses one brings in as a result of an investment.

It includes income generated from dividend, interest or rental payments, and any gains or losses from a change in the asset’s market value.

This is normally expressed as a percentage of the purchase cost.

Prudent investors recognize that a precise definition of ‘return’ is situational and dependent on the financial data input to measure it.

Risk and return are opposing concepts in the financial world and the trade-off one faces is the extent of risk one is willing to take to achieve an acceptable level of return.

The risk return trade-off is an effort to achieve a balance between the desire for the lowest possible risk and the highest possible return.

Generally speaking, at low levels of risk, potential returns tend to be low as well whereas, high levels of risk are typically associated with potentially high returns.

In a relatively risky investment, one may likely lose everything, or conversely earn higher should all odds work favourably.

Risk-return trade-off

The appropriate risk-return trade-off is dependent upon a variety of factors including risk tolerance levels of individual investors.

Different investors will have different appetite for the level of risk they are willing to accept.

Some will readily invest in low-return investments because there is a low risk of losing the investment.

Others have a higher risk tolerance and so will buy riskier investments in pursuit of a higher return, despite the risk of losing their investments.

How do you determine what risk level is most appropriate for you?

This isn’t an easy question to answer.

It generally depends on your personal or investment goals, income, personal situation, etc.

Hence, an individual investor needs to arrive at his own individual risk return trade-off based on his investment objectives, his life-stage and his risk appetite.

Some investors develop a portfolio of low-risk, low-return investments and higher-risk, higher-return investments in hopes of achieving a more balanced risk-return trade-off; a practice usually referred to as diversification.

Diversification

Diversification is more commonly explained by the phrase “do not put all your eggs in one basket”.

It is a risk-management technique that combines various investments within a portfolio in a bid to minimize the impact that any one security will have on the overall performance of the investment portfolio.

Diversification aims to maximize return by investing in different areas that would each react differently to the same event.

For example, having a combination of investments in fixed deposits with banks, investing in government bonds, investing in a range of shares across different industries and so forth.

A combination of asset classes will reduce your portfolio’s sensitivity to market swings, and so reduces the overall risk you would take on individual asset class.

Often the novice investors tend to invest based on returns the asset is promising.

Risk Portfolio

However, assessing the risk profile of that investment is equally important to make a comprehensive investment decision.

There is a range of financial products available in the market to choose from, but choosing one which best suits ones financial needs is always imperative.

In that regard, it is worthy to mention that HFC bank, being your proud local bank, continuously strives to align its financial solutions to the financial goals of its customers.

You may always seek investment advice from our learned bankers and choose from a range of products such as term deposits, savings products or interest bearing cheque accounts to better diversify your investment portfolio.

Feedback: maraia.vula@fijisun.com.fj

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