Investment is intrinsically linked with risk and return – they go hand in hand. Which is why it’s important that any investment vehicle matches your feelings and preferences towards risk and return. There are a wide variety of different asset classes available in which to invest and there are commensurate risks attached to each one.
By diversifying, investment risk can be mitigated as part of your overall investment portfolio. In addition, spreading your investments over a wide range of asset classes and different sectors enables you to reduce the risk that your portfolio becomes overly reliant on one particular asset’s performance.
Depending on your risk profile, this will determine the mix of investments you choose. It’s important that you only invest in what you can afford to lose and have savings to cover any short- to medium-term needs. As an absolute minimum, you should consider holding at least three to six months’ earnings in a savings account that offers immediate access, in case of an unforeseen emergency.
The key to diversification is selecting assets that behave in different ways. Some assets are said to be ‘negatively correlated’. This may include bonds and property, which often behave in a contrarian way to equities by offering lower, but less volatile returns. This provides a ‘safety net’ by diversifying many of the risks associated with reliance upon one particular asset.
It is also important to diversify across different ‘styles’ of investing, such as growth or value investing, as well as diversifying across different sizes of companies, different sectors and different geographic regions. Growth stocks are held as investors believe their value is likely to grow significantly over the long term, whereas value shares are held because they are regarded as being cheaper than the intrinsic worth of the companies in which they represent a stake.
By mixing styles that can out- or under-perform under different economic conditions, the overall risk rating of your investment portfolio is reduced. Your attitude to risk for return is determined by your circumstances, age, goals and other factors and these will help you decide what type of investments to hold.
A general rule is that the greater the risk you’re prepared to take, the higher the potential returns could be. On the flip side, any losses are potentially greater. If you are unwilling to take any risk with your money, you may be better off putting your savings into cash, but you should be aware that inflation can eat into the value of your money.
