Understanding investment risks
Investing for your long-term financial security can be daunting. There are many decisions to be made and one of these is how much risk you are prepared to take. This will be determined by a number of factors. To help you decide on the types of investments that can help meet your financial goals, this article takes a look at the different types of investment risk and how this relates to returns.
Types of investment risk
Generally, there are three key types of investment risk that you need to consider when investing:
Losing your initial investment
Lower than expected growth in the value of your investment
Lower than expected income return.
The risk/return spectrum
We would all love to find an investment with low risk and high returns. But in reality, risk and return are inversely related, so that the lower the risk of an investment, the lower its long-term returns are likely to be.
As shown in the following chart, fixed income and cash investments will generally be lower risk (these are also known as defensive assets), and assets such as real estate investment trusts and shares are generally considered to be higher risk (known as growth assets).
The risk/return spectrum
Source: AMP Capital; for illustrative purposes only
What’s your appetite for risk?
Your appetite for risk will depend on your life stage and whether you want to grow your savings over the long term or need to draw a regular income. Usually, your age and relative proximity to retirement will determine whether you’re investing for the short term (one to three years), medium term (three to five years) or long term (more than five years)1.
Investment markets move up and down over time. If you want to invest for many years you may be prepared to take on more risk in your investment portfolio. This means you’ll have time to ride out any short term fluctuations in investment returns and benefit from the potentially higher returns offered by growth investments such as shares.
As you approach retirement, or when saving for a specific goal such as the purchase of a home, you are less willing to risk losing your savings. This is particularly true when markets are volatile, and the risk of capital loss increases. At this time, you might put a greater emphasis on investing in defensive assets, such as cash and fixed income.
This strategy works well when interest rates are high and exceed the rate of inflation. However, when rates are lower than inflation, investors will see the value of their investment eroded over time by rises in the cost of living or inflation.
Reducing risk through diversification
Diversifying your investments means spreading them around so you also spread your risk. Many people invest across the main asset classes such as shares, property, cash and fixed income, and also invest in a number of different areas within each asset class.
Diversification can help lower your risk because different asset classes generally perform well at different times.
For instance, some assets may do well when the Australian dollar is rising whereas others may do better when the Australian dollar is falling.
By placing your money across a number of different asset classes and investments, the positive returns you receive from one investment may offset negative returns from another investment caused by economic or investment cycles.
¹Australian Securities and Investment Commission/ MoneySmart website, www.moneysmart.gov.au accessed 26/11/12
Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs.