Risk, Rewards & You As An Investor

Before you rub your hands, dig in your heels, and execute your financial plan, there is another basic principle you need to constantly remember and that is, the higher the return on investments, the higher is the risk involved.

This is a fundamental principle of investment, the risk reward trade-off associated with every investment decision you make.

When you buy or sell an investment product, you always have the risk of losing your money. It is just that the degrees of risk vary with each product.

Generally, the products that promise the most returns (like futures and options and high flying stocks) are the most risky investments - so that the more risk you take with them, the greater is your potential reward, but you also have a greater chance of losing money.

The reverse applies: with safe products like bank deposits and bonds which give small or steady but hardly glamorous returns, you have less chance of losing your money because they are less risky, but your potential return is also less. This is what it is meant by trading risks for rewards.

As an investor how risky your investing becomes depends on you. Or rather how much risk you can tolerate. Risk means taking a chance, with the outcome not guaranteed to be in your favour. Tolerance is how comfortable you feel with an unfavourable outcome.

Whether you can afford to take risks and to what extent depends on how secure you are financially (that means your net worth, your income and future earning potential), your personality and your financial goals.

The investment books never fail to include investor risk profile quizzes to help you determine your risk tolerance. Do these tests to find out what kind of investor you can comfortably be:

conservative,
moderate or aggressive.
An aggressive investor would take bigger risks looking for larger gains.

A conservative investor would seek out safer investments and be content with having his investments earn a steady income. An in- between moderate investor is cautious but is willing to take some risks for a better return.

For a quick inkling of how well you stomach risks, use the sleep test. Can you invest your money into an asset and still sleep soundly at night? If you can't, then that investment is not for you. Understanding Investment Risks But what are all the risks that investors like you have to face?

One is fundamental risk, which applies to all investments. It is the risk inherent within a business enterprise and is affected by how well managed the company is and how it fares competitively in its market. The best way to minimise the effects of this risk on your portfolio is to diversify; that is, invest in different companies in different industries within the same asset class.

Next is market risk, also known as technical risk, which relates to how well the market of your investment fares in regard to economic factors like business cycles, inflation, unemployment. For example, real estate may perform better than stocks at a particular period of the economy.

Again, managing market risk means having a balanced portfolio - diversifying across asset groups and monitoring the economic scene with a view to identifying the winners and losers.
Interest rate risk is how your investment responds to interest rates.

Contrary to common assumptions, interest rate risk does not only affect the bond market. It affects the stock market too; while stocks have other factors that directly affect them, they will frequently react in the same inverse manner as bonds to interest rate moves.

Inflation risk is the risk that inflation will outpace your investment to erode the value of your investment dollar. It is a purchasing power risk. So you would have to look for stocks, real estate and investments that will, over time, beat the inflation rate. And also remember to factor in inflation when you are calculating the expected returns from your investments to get a true picture of your gain.

And lastly, liquidity risk is answering the question how fast can I convert my investment assets into cash at full value? Bank deposits are at the low end of liquidity risk while real estate investments are locked at the high end.

Shares and unit trusts are pretty liquid, requiring a few business days to receive your money upon selling them.Which Investor Type Are You? Here are some examples of investor risk profiles and the typical investments matching their personalities and objectives.

Investor Profile Typical Investments Here are some examples of investor risk profiles and the typical investments matching their personalities and objectives.

Highly conservativeGovernment securities, bank-backed securities, trustee securities
Conservative A broader range of income-only investments, debentures, corporate bonds, certain insurance products

Middle rangeUngeared property, growth shares, investment-linked trusts (with growth emphasis), international investments

Entrepreneurial Geared property, growth shares, investment-linked trusts (with growth emphasis), international investments

Speculative Options trading, futures, exotics, collectibles

Note: The above table is an indication only. To be accurate, other characteristics and factors need to be taken into consideration, and there is also overlap. Hence, some investors would disagree with the categories of investments matched to the risk profiles.