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The financial world we live in has changed dramatically in the past few years, leaving investors with a decidedly nasty taste in the mouth. With market volatility, bank failures, bailouts, the euro crisis, riots and disorder, it seems there are few safe investment havens left for investors. With such a negative outlook, assessing your risk tolerance will ultimately help identify better investment decisions.
If it were possible, we would all like to earn the highest possible return, with the lowest possible risk! However investing involves a trade-off between the two. As a general rule of thumb, the higher the potential return an investment delivers, the higher the risk. By the same token, if you can't stomach too much risk then you will have to accept a lower return on your investments.
The problem with difficult investment periods such as we are currently in, is that investors are tempted to boost returns without taking into account the level of risk attached. This is possibly the worst strategy to take when in the current economic climate — protection of capital should be paramount.
There are, however, more sensible approaches that offer the potential for consistent returns, while at the same time keeping the amount of risk you take on board in check. How? First, one of the key tasks for an investor is to determine how much investment risk to take on. This decision will depend on psychological, financial and other factors. The result should be that you decide upon a level of risk that you are comfortable with.
When you know the level of risk you are prepared to take, you can maximise your reward for taking on that risk. This is where a diversified portfolio can play a part.
Global assets and markets perform differently at different times, so one of the most effective ways to achieve consistent returns is to diversify and spread your money between a range of assets, sectors and markets.
Diversification gives you greater potential for growth because your portfolio is not dependant on any one company, fund or sector doing well. So if one of your investments is performing less well, others should be performing better to compensate. Basically, by not putting all your investment eggs in one basket you reduce your potential risk.
But what about returns? Evidence suggests that if you take a long enough forward-looking perspective, investment returns ought to converge no matter what the starting point of the market. A good discipline to adopt is to think of long run return assumptions on the basis that the investment landscape of money invested five or ten years from now is likely to be very different from today. This is helpful, because it allows us to separate short-term more opportunistic thinking from long-term strategic planning. If we take a long enough time horizon, then it helps ignore short-term market dynamics that often result in poor investment decisions, as shown in our risk/return strategy examples on the right.
A sensible asset allocation has never been more important than in this post-financial crisis period. You’ll need an investment portfolio that protects your capital, but can also cope well with a wide range of market conditions. The fundamental challenge is the lack of certainty about returns across the investment landscape and the increase in risk it brings. But good quality, well-diversified assets should, over the longer-term, provide the opportunity for greater returns with an acceptable risk exposure.
Mark Brownridge is a Research and Development Analyst, Mazars Financial Planning.
If you would like to ask the author a question on this or a related topic email: email@example.com
Here we’ve listed five key points you need to take into account when developing a suitable risk/return strategy.