Risk Management
When constructing investment portfolios it is essential that we understand risk.
You may have considered your tolerance to risk in the past, and may have thought of this in terms of a scale of 1 to 10. Many people would say they fall somewhere between 3 and 5, but what does that actually mean and how can this information be used effectively when constructing an investment portfolio?
Risk is subjective, and even then an individual’s attitude to risk can vary depending on how well their investments are performing. When investments are performing well there is a tendency to downplay the risks and when they are performing poorly, to assume them to be much greater than they actually are.
Most of us accept that to achieve higher returns we need to take some risk. However, not all risks are worth taking and more risk does not automatically mean higher returns. The challenge is to make sure that any risk we take has the potential to reward us with the highest return commensurate with the level of risk taken.
While a cautious investor may favour saving in a bank account, they could improve the prospects for longer-term returns, and reduce the risks posed by inflation, by investing in a particular form of Government Bonds.
By focusing on risk, and more particularly on managing risk, we can reduce many of the emotional highs and lows often associated with investing and achieve more consistent returns and less sleepless nights.
The key to long-term investment success is having an appropriate asset allocation strategy in place.
Investment should not be about trying to achieve the maximum return at all costs. This approach may work but is just as likely to end in failure. It could be that many investors are taking more risk than they realise, and often it is not until a period of poor performance that this comes to light.
All investors should ensure they are striking the right balance between what they are looking to achieve and the risk they are prepared to take. To do this effectively they need to have an understanding of risk and reward and of how the underlying investments in their portfolio blend together.