Friday, October 8, 2010

Return and Risk

Knowing Return and Risk
Return and Risk are Primary consideration in Investing. They should likely form the basic for all your investment decision. Thus it is a MUST that you understand what return and risk are and how they are originate and they are related.

You invest to get return. It simply get Gain (positive return) or lost (negative return) on your investment after you have sold it. When you invest, you expect a particular return level . However, the actual return may differ from your expected return. Investing is based on expected return. It is therefore that you do not have unrealistic expectations

Many think of investment risk as the possibility of losing money. This is a valid concern. Other define risk as the uncertainty of receiving the expected returns. All can these can be measured and quantified by a statistic. Different investment products have different degrees of risk or volatility. Look at the various product like shares, bonds and cash deposit on their annualised return and Risk.They can be classified into two categories:-

(1) Systematic Risk -factors that effect the market in general and it include things like general economic conditions, changes in interest rate or a sudden adverse change in market conditions. And as investor, you cannot avoid these risk

(2) Non-Systematic Risk-factors that are applicable only to the investment itself like quality of a company's management and the sustainability of its product development strategy.You can reduce this risk by spreading your investments over a number of holdings.

Thus, the risk-return trade-off is an important consideration in investment - Higher expected returns have higher risks. Investors not able to take risk have to contend with lower returns. You need to apply the Risk-Return trade off when purchasing the product.
When deciding on the appropriate level of risk, you need to consider two issues. Firstly, what is your tolerance level of risk and secondly, is the length of time you are investing for.

"Don't put all your eggs in one basket", is the basic idea behind Diversification and it is a powerful tool in managing risk. Diversification involves spreading your investments over a variety of assets and securities to avoid excessive exposure to any single source of risk. If you put all your money in a single security, what happen if the insurer goes bankrupt?

To diversify effectively, you must apply the ideas of Correlation, which is a measure of the tendency of a security or investment class to follow that of another. Assets with returns that move in the same direction are positively correlated; if their returns move in opposite directions, they are negatively correlated. Investing in different securities in different asset classes like cash, bonds and shares is a way to go.

When you invest, you operate with a Time horizon in mind. It is the time available to invest to achieve your financial goals. Example, if you are 40 years old and investing for retirement at age 60, then your time horizon is 20 years. Therefore, you can use Time and Return to grow your money or Time and Risk to stomach more risk with time to invest in Riskier assets.

Dollar cost averaging can reduce risk in a long Investment horizon. The idea is to invest a fixed sum of money at a regular interval, regardless of whether the market is rising or falling. If you invest in only a certain time, you may buy when prices are at or near the peak.

Reference: MAA financial Planners SG

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