Thursday, June 18, 2009

Risk and return

One of the most important concept in investing is the concept of risk and return. The lower the risk the lower the potential for the return and conversely the higher the risk the greater the potential of return. In order to be a successful investor you should be able to assess what is your risk tolerance and what is the level of risk in your portfolio. Finally you should be able to decide what is the level of risk that goes with your risk tolerance.

Riskiness of investment

Investments can classified in term of risk. Some investments are quite safe and as a result the possibility if losing your capital is low. Others are riskier because the possibility of losing your capital increases and as a result the person in need of the capital will have to compensate you for taking the risk and hence you will obtain the higher return. Probably the person that raised the capital is doing an activity that has a chance of failing.

The table below shows the different investment instruments in term of the risk associated with them.

As you see, the different instruments can be classified in three different categories depending on the level of risk associated with them and the potential for return.

Group one investment instruments are relatively safe and as a result there is little possibility of losing your capital. Even though on rare occasions relatively safe companies and banks can go bankrupt and make you lose the money in your bank account or the capital of your bonds.

Group two investment instruments are moderately safe and as such give average return. Their is always the possibility of a company going bust or than a town or a state will default on payment. For example if you hed stocks in Leyman Brothers your share will have no value as of now. Also states like California may default on payment of bonds in the future if the deadlock on budget expenditure is not resolved.

Group three investment instruments are highly risky and speculative. There is a great possibility that you will make great return or great losses. You can have bonds from Iceland for example that are highly speculative and you can lose your capital if you invest in these but if the country can hold until the bond reaches maturity, the interest earned will be high and you will get your capital back.


Risk Tolerance

Before jumping in with your hard-earned money and starting to buy investment instruments you need to determine your risk tolerance. The risk tolerance is simply how much risky investment you can hold in your portfolio and you are comfortable with. After you have determined your risk tolerance you will then be able to determine the type of investment instruments you will be able to buy.


Three factors will affect your risk tolerance.

Time

When you invest, you will need to determine your goals. And the time left to attain these goals. If the time left is long then you can afford to take more risk because should you suffer a loss you will have time to recover the loss. You will invest heavily in stocks, company bonds, real estates, etc. You will be an aggressive investor.

However if the time left is short, then you would want to invest in safe instruments. You will not want to risk losing in your money. May be your son will go to university next year, or you will retire in the next ten years. These people will probably shift out of shares and company stocks and invest in safe instruments such as CDs, government bonds and debentures, blue chip stocks or bonds. You will be a conservative investor.

Acceptance of loss


Some people even though they know that they have a long term investment plan, they are not satisfied to the idea that in the short term their investments can decrease in value but keep on increasing in value over the long run. These people will thus choose to be conservative investors. They will contend themselves with measely and mediocre return.

If you want to know how to allocate your portfolio read this post.

You will probably want to read this post on diversification.


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