What is life without a risk? Every decision you make, whether it’s buying a car, going on a rollercoaster ride, or starting a family, carries some form of risk that things will not go as expected. But to isolate by locking yourself in a room is to pay the highest price: you miss everything.
Yep, for day 3 of Investment Education, we’re covering risk.
In financial terms, we define risk as the chance that an investments actual gains will differ from its expected return - in other words, it’s the possibility you’ll end up losing money or making less than you hoped.
The golden rule of investment is the higher the expected return, the higher the risk. This is known as the risk-return trade-off. A high rate of return is compensation for the high risk. There’s no such thing as high return investment with no risk at all. However, there are strategies that can be used to manage and mitigate risk.
Word of the day: Volatility
The degree that the price of an investment moves up and down. Volatility is concerned with how fast an asset moves in value and is a measure of the risk of that asset. The higher the volatility, the higher the risk.
Diversification
We’ve all heard the phrase “don’t put all your eggs in one basket”. If we change this to “don’t put all your money in one investment” we are talking about diversification.
Every asset that you buy comes with the market risk - it’s value could drop. There is always an unexpected event. So, by spreading the money into an investment portfolio across different assets, it can reduce the risk that all of them will fall in value at the same time.
On day 1, we have covered unit trusts. Investing in unit trust funds is an excellent and inexpensive way to achieve diversification because they give you exposure to many different companies, different sectors as well as other asset classes.
Opportunity Cost
You buy a fancy handphone and with that same amount of money, you could have bought another brand with similar features but cheaper. This is the risk that when you make an investment decision, and with the benefit of experience, you realise you could have done better elsewhere. This is a risk people forget about when they keep their money as cash. Yes, this eliminates some risks, but it carries a heavy opportunity cost.
Risk Tolerance
Your risk tolerance is how comfortable you are with taking risk. It describes how much risk you are willing to take on in achieving your investment goals. If you take on too much risk and can't take up an investment failure, you could become emotional and sell at an unsuitable time.
Investment Horizons (Timeframes)
An investment horizon, or timeframe, refers to the total length of time that you expect to hold an investment. Investment horizons can range from short-term, just a few days or months long, to much longer-term, potentially spanning years to decades. Your EPF is an example of a long-term investment horizon.
When investors have a longer investment horizon, they can take on more risk since the economy has many years to recover from downturn. That’s why you often hear that in the long run, the market tends to go up.
Conversely, a shorter time horizon opens you up to the possibility that you will have to withdraw your investment during a market downturn, at a low price. Therefore, investments with short time horizons should generally carry less risk to reduce the likelihood of the investment decreasing in value in the short term.
Investment Horizon can be more important than Risk Tolerance when deciding which investment you should choose. Especially when its term is very short or very long.
