1. Risk profile or risk tolerance
Your risk profile, which is often discussed by financial advisors, or your risk tolerance is your ability to withstand losses in your portfolio. Some people compare it to your ability to sleep at night - if your portfolio falls 5%, can you sleep at night? What about 10%? 20%? From there you can begin to understand what your risk tolerance is. This determines how you should invest with it. Your risk tolerance will change throughout your life and your standard of living. If you have a long time to bear losses or have fewer current financial responsibilities, you may be more open to taking greater risks. Usually as you get older and have less time to bear the losses incurred, your risk tolerance will decrease. When calculating your risk tolerance, it is also important to look at your total wealth and understand exactly what you are risking with a particular investment.
2. Risk vs. reward or relative risk and potential return
glossary diversity
The potential reward from an investment is related to the amount of risk you want to take. For example, if you keep your money in a bank, it is considered safe because there is a government guarantee. After that, the rewards you receive are low. If you invest in a company through stocks, the risk is greater because there is a possibility that the company may do well or not. Blue-chip stocks, which are invested in a large company with a long track record, are seen as safer than smaller and newer companies so their reward potential is lower for blue-chips than newer companies. Speculative investments, where you take a greater risk that the investment will pay off, need to give you a good reward to motivate you to take the risk, and this is how risk and reward relate.
3. Diversity
Variety ensures you don’t put all your eggs in one basket. In terms of investment, this can refer to industry, geography or asset type. Your investments should be diversified to protect as much of your total assets as possible in the event that a market segment declines. For example, your investment portfolio may consist of cash, fixed interest, real estate, and equity. This is asset diversification. To diversify further - real estate can be further diversified to include commercial, industrial, residential and more, and can be further diversified based on location - nationally and internationally. Equity and other investments can also be diversified.
4. Index volatility
The VIX is an accepted marker for volatility. Better known as a volatility index, this is an indication of whether there is excessive fear or optimism in the market. It tracks the volatility of the S & P500. When sentiment reaches an extreme level or another, the market will usually change direction. When the VIX is low then volatility is low and when the VIX is high, volatility is high - and this is usually driven by market negativity.
5. Manage risk
Managing risk is the effect of time fluctuations on your investment. If you don’t have to access investments for some time, there will be time to recover, however, if you are retiring or nearing retirement, the fall in your assets will have a bigger impact. There is also a risk when retiring, especially in the pension phase, that if you have to withdraw your funds at a time when certain assets have performed poorly, the losses will increase over time. This is why when people reach retirement they may invest smaller amounts in high growth investments.
6. Inflation risk
Inflation risk refers to the influence of inflation on your investments. If inflation increases at a rate greater than your investment, you will definitely lose money. This is because inflation is reflected in the prices of goods and services and if your ability to buy them does not increase at the same rate or higher, your ability to buy them in the future will be lowered, and you will only be able to buy less.
7. Interest rate risk
This refers to the ability of interest rates to influence your investments. For example, if you hold a bond and interest rates rise, the value of your bonds will fall because demand will be lower if interest rates rise to higher levels elsewhere. However, if rates fall, more people tend to invest in equities and the price will rise.
8. Risk focus
Concentration risk refers to the potential of a single investment or investment class to threaten an entire portfolio. This usually refers to the concentration of territories, events, commodities, investments, political outcomes or credit. If any of these areas are impacted, the concentrated exposure has the potential to affect the entire portfolio.
9. Market risk
Market risk is focused on the performance of financial markets. Usually all investments may be affected by a market downturn like the current epidemic. Hedging a portfolio can sometimes help reduce falls due to market risk, by buying options to protect against downside movements.
10. Liquidity risk
Liquidity risk is something that many super funds are facing as people take the opportunity to be able to access their super to help through the COVID-19 financial downturn. The risk is you will not be able to turn investments into cash to meet short -term money demand. This may be because investments are many, hard to sell items - such as large real estate developments - or investments you have are hard for buyers to find. Liquidity risk will usually result in a large loss of capital in the event of a need to sell in a buyer’s market. To avoid liquidity risk, investors should ensure that short- to medium -term needs can be met without having to use parts of their portfolios that are potentially illiquid.
11. Currency risk
This is the risk that the exchange rate will rise or may affect the investments you have made in different currencies. For example, if you invest in the US with the Australian dollar and the US dollar rising, your US investment will also increase in AUD terms. However, if you invest in the US with the Australian dollar and the US dollar depreciates against the AUD, your investment will be worth less in AUD. You can hedge currency risk with many investments - however, currency risk may be part of your investment strategy.
12. Alpha
Alpha is the primary measure of the amount of investment returned relative to the market index or benchmark to which it is compared. Higher performance amounts are referred to as alpha investments.
13. Beta
Beta is the amount of volatility of an investment relative to the market or benchmark. The base number for beta is 1 which means it is moving in line with the market. If <1 it means it is less volatile than other markets, if> 1 it means it is more volatile than other markets. For example, if 1.2, it is 20% more volatile than other markets. 14. Sharpe Ratio Developed by Nobel prize winner William F Sharpe, this ratio is used to help investors understand the return on investment versus its risk. The ratio is based on the average return earned in excess of the risk -free rate per unit of volatility or total risk. If the ratio is greater than 1, it is considered good, if it is higher than 2, it is rated very good and at 3 or more, it is considered very good. If it is below 1, it is seen as sub -optimal. The risk -free rate is usually determined by the shortest government bond.
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