Risk versus Return
Image source: investopedia.com
Over the years I have been asked a lot of questions by a wide range of people about investments such as:
What should I invest my money in?
Should I invest in the share market?
How do I get a better return?
The most important thing to understand with investment decisions is the concept of risk versus return. This concept simply states that the investment return on an asset is linked directly to the amount of risk associated with that investment asset. The lower the risk the lower the return and conversely the higher the risk the higher the return.
What does this mean?
Let’s take a cash deposit in Government stock as an example. There is very little risk that you will lose your money with this investment. The Government is very unlikely to fail and your money is very safe. You will also have no growth in the value of your cash deposit (unless you compound the interest) and your investment on Day 1 will be the same as on Day 100. This is often referred to as a risk free asset. So the risk is low and as a result your return is low - currently about 1.08% for a 10 year Government Bond.
Now compare this to an investment in the share market - or equities. Here your risk has increased dramatically as you are investing in individual businesses that do not have the financial stability of a Government. They are also subject to economic conditions, market perception and inflationary risks within the market which might affect their value. Your potential returns however on this type of investment reflect the increased risk. Over the past 3 years the New Zealand Stock Exchange Top 50 companies index has averaged 11.95% return. A much higher return but a much higher risk.
Property is another investment asset and here there are two types:
Commercial Property. Currently this could earn you about a 5-6% rental return per year and maybe some capital growth. The risk however is that you are taking on tenancy risk with a business and property management issues.
Residential Property. At the moment you should earn about 3-4% rental return with limited capital growth offset by similar but smaller risks associated with residential tenants.
There are other investment assets and each have their own risk profile which you must evaluate against your own risk profile - that is for another day.
These are the things to remember:
Any investment that is a return higher than “cash in the bank” will have more risk associated with it
There is no such things as a “free lunch”. If you want a higher return you must accept a higher risk
Understanding your risk profile and appetite for risk is vital in any investment decision
There are ways to mitigate your risk - diversification, invest less, take more security or don’t invest at all
James