Is there such a thing as an investment that offers high returns with little or no risk?
Have you ever worried or had trouble sleeping over an investment you made – whether that be property, shares, your super fund or your practice?
Have you ever looked across your whole financial situation and wondered if you are taking too many risks, or conversely, being too conservative and feel you should be doing more with your idle cash?
To explore these questions further, let’s first look at the basics of investing:
Whenever you invest – whether this is cash in your offset on your home loan, a term deposit/high interest savings account, managed fund, shares, property or your practice – you are accepting risk that this investment won’t result in the outcome you are seeking.
- You may expect your cash investment to keep pace with inflation, but inflation is higher than the interest rate earnt,
- You may expect your investment to grow in value, but its value actually falls,
- You may expect regular income from an investment of 10% p.a., but the income on your investment falls to 5% p.a., or
- You may expect to be able to access your cash invested whenever you need it, but your managed fund suddenly freezes withdrawals.
It’s impossible to avoid all risks when you invest. Many think that keeping their money in cash is completely risk-free, but what is often not factored in is the likelihood the interest you are earning on this cash is not sufficient to prevent the real value of the cash being eroded by inflation. In addition, what is the opportunity risk of staying in cash versus likely higher long term returns in other investments?
The important thing is to understand the risks and then invest at a level of risk you are comfortable with. To do this, it is important to consider the different levels of risk tolerance and to determine the level you are most comfortable with.
Your investment risk tolerance
Essentially, risk tolerance is your ability to cope with fluctuations in the value of your investments. Some factors which might influence your risk tolerance include:
- Your age,
- Your previous investment experience,
- Your ability to recover from falls in the value of your investments, and
- Your health.
For example, as you approach retirement, your risk tolerance may become more conservative, as you don’t have as much time to recover from major declines in the value of your investments.
To decide where you fit on the risk tolerance scale, you should have your risk tolerance formally assessed by your financial adviser. Simplistically though, you can ask yourself this question: “How would I feel if I woke up tomorrow and found the value of my investments had dropped by 20%?”
If this drop would cause you to worry a lot and perhaps sell your investments, then you probably don’t have a high investment risk tolerance. This is because it could result in you selling at the worst possible time and compounding your losses, as well as the stress this may cause you..
However, if you feel a drop in the market is a great opportunity to invest further, then you are probably very comfortable with market fluctuations and comfortable with a higher level of investment risk.
Overall, your risk tolerance is the lesser of the risk you are comfortable with and the risk your timeframe will enable you to take.
A good example to illustrate the above, are the below tables detailing the investment options and asset allocation ranges available with QSuper.
What is important to note is how the ‘Return Objective’ is correlated with the ‘Risk’ and ‘Investment Timeframe’ for that investment option.
This explains why higher potential returns usually go hand-in-hand with higher risk. i.e. riskier assets, such as shares and property, will fluctuate in value more, but should result in a higher return for you over the long term.
So what should you be doing?
There is no easy path to investing success. A combination of high returns and low risk does not exist. To achieve high returns, you generally need to accept high levels of risk with the potential for significant fluctuations in the value of your investment.
To ensure your investments are invested to meet your long-term goals, your aim should be to protect your capital and maximise your returns, without exposing yourself to risk that is unacceptable to you.
How much investment risk should you accept?
If assessing your investment risk tolerance is of interest, please contact us to discuss further.