Understanding the relationship between risk and return will help you choose the right investments. Generally speaking, investments that have a greater investment upside also have greater potential risk.
The simplest way to illustrate this is with examples:
- A bank account is a great example of a low-risk investment. It’s guaranteed by the government so there's almost no chance that you'll lose your investment. In addition, the value of your investment won’t fluctuate wildly (these fluctuations are known as volatility). Your investment will be worth roughly the same each day. The downside is that the potential return from investing your money in a bank account is quite low and may not exceed the reduction in the buying power of your money caused by inflation.
- You could increase your potential return by investing in a term deposit instead of a bank account, but that may increase the level of risk slightly. Your money is locked away for a period of time, which means you can’t access it if you need it, or if a better investment opportunity comes along (for example if term deposit rates go up).
- Shares are a classic example of a high risk, high return investment. If you invest in shares, the value of your investment will change every minute of every day; sometimes quite significantly. In addition, it’s possible to lose your investment entirely if the company you’re invested in collapses. On the positive side, the share market in general has shown impressive performance over the long term and there are many examples of individual shares that have provided truly spectacular returns to investors.
Reducing risk
Fortunately, there are ways to reduce risk and manage your investments.
Give it time
Investments with high potential return can be volatile in the short term but tend to be more consistent over longer time periods. For example, if you invest in the Australian share market for a period of 12 months, there's a reasonable chance of a negative return. If you invest for 10 years, the chance of a negative return is lower.
Diversification is vital
Diversification involves spreading your investments across a number of asset classes (shares, property, fixed interest, cash), a number of sectors within those asset classes and a number of quality assets within those sectors. A well-diversified portfolio means that poor performance in one area is less likely to destroy your overall portfolio. Hopefully other asset classes or sectors will perform better and will compensate.
For financial advice you can depend on speak to the AMA Financial Services team on 1800 262 346 or email advice@amafp.com.au.
A.M.A. Services (WA) Pty Ltd trading as AMA Financial Services 47 008 671 458 is a Corporate Authorised Representative of Consultum Financial Advisers Pty Ltd. ABN 65 006 373 995 l AFSL 230323.
This is general advice only and does not take into account your financial circumstances, needs and objectives. Before making any decision based on this document, you should assess your own circumstances or seek advice from a financial adviser and seek tax advice from a registered tax agent. Information is current at the date of issue and may change. You should obtain a copy of the Product Disclosure Statement available from the product provider or your financial adviser and consider this before you acquire a financial product. This information and certain references, where indicated, are taken from sources believed to be accurate and correct. To the extent permitted by the Law, Consultum, its representatives, officers and employees accept no liability for any person that relies upon the information contained herein. From time to time, we may send you informative updates and details of the range of services we can provide. If you no longer want to receive this information, please contact our office to opt out.