This article is the second instalment in a series we have developed on investment fundamentals. The first article of the series can be found here.
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Understand the nexus between risk and return
This is a fundamental principle. Every financial decision involves some degree of risk. Risk is a broad term, with many possible definitions, but most often it is the variability of returns or the unreliability of the investment that an investor is concerned about. In adopting greater investment risk, there is an expectation of receiving better investment returns. Generally, the higher the potential return of an investment, the higher the risk; however, there is no guarantee that you will actually get a higher return by accepting higher risk. If investment returns sound too good to be true, then they usually are. Don’t be enticed by opportunities offering a 12% return, thinking they’re risk-free.
Source: Switzer Report (https://switzersuperreport.com.au/)
Recognise the effects of inflation
A dollar today is worth more than a dollar tomorrow or, more simply, your dollar doesn’t buy as much tomorrow. As prices for goods rise, your cost of living increases. As a result, it is necessary to “inflation-proof” your portfolio and ensure that it generates a return of at least 2-3% p.a. just to keep pace with inflation. Right now, a cash-only investment will not deliver a net positive return on your capital, so most of us need to take on some level of risk in order to protect our capital from the eroding effects of inflation.
Figure out what sort of investor you are
Is your inclination to take on more risk in the pursuit of higher returns? Would you panic if your portfolio value fell by 10% or 20%? Understanding your individual preferences and accounting for them in the investment decision-making process is vital. If you’re cautious, then it may not be prudent to expose a large portion of your capital to the volatility of the share market. You need to sleep well at night!
Work out your personal capacity for risk
There are many factors that may influence your capacity for risk, and all should be considered when making investment decisions. Having an unstable employment situation or having a large portion of your capital tied up in a family business or in illiquid (not readily saleable) assets may necessitate a more conservative investment approach. Other important considerations are your investment time frame and the adequacy of your own “capital safety net”.
Diversification is key
No one asset class or investment consistently outperforms the others and not all asset classes or investments are perfectly correlated (i.e. move up and down in a synchronised way). Diversification can be defined simply as “not putting all your eggs in one basket”. A diversified portfolio contains a variety of asset types and investments in an attempt to limit the exposure to any single asset class or individual asset. The main traditional asset classes are Australian and international property, equities, fixed interest and cash. Other “alternative” non-traditional asset classes exist; some exhibit more growth-oriented characteristics (e.g. infrastructure) and others exhibit more defensive characteristics (e.g. credit that offers a better yield than traditional investment grade credit due to illiquidity, credit worthiness or complexity). A diversified portfolio has a mix of all asset classes and various investments within those asset classes.
Start with the end in mind
Before you take on more risk with investments or gear (borrow) to invest, make sure you understand and are comfortable with the risks and whether they are required or rewarded. Work out what you need to cover your expenses in retirement and seek some analysis or financial modelling to determine if you’re “on track”. Do you need to adopt more risk to achieve your financial goals? Recognising when risk could be rewarded is a more difficult exercise but, obviously, adopting more risk when markets are down (cheap) is far more sensible than doing so when markets are high (and expensive). A higher purchase price will ultimately result in a lower return.
Taking these fundamental principles into account when planning your approach to investing can help you establish a strategy that accounts for your personal preferences, financial situation and ideal investment outcomes. If you would appreciate the help of a professional with developing an investment plan tailored to your individual situation, or are looking for a fresh perspective on your current strategies, please get in touch.
Disclaimer: This article contains general information only and is not intended to constitute financial product advice. Any information provided or conclusions made, whether express or implied, do not take into account the investment objectives, financial situation and particular needs of an investor. It should not be relied upon as a substitute for professional advice.