Risk comes from not knowing what you are doing.
Warren Buffet
Most of us are commonly attracted to investments that offer high returns and, more often than not, we focus on the return and forget to assess the risks involved with that particular investment.
Risk (or return trade-off) is “the ability to sleep well at night” test. It is not simple to determine the appropriate risk level for you. Handling financial risk is influenced by things like:
- Your current financial health,
- The investment horizon, and
- Realistic return expectations.
These factors influence the ability to take on risk. You can be willing to take on additional risks but your ability to take risks is low. Before you make any investment decision it is critical you decide the amount of risk you are willing to comfortably take.
A key point to note is, higher risk does not always mean higher return and that the probability of not achieving that high return is also high.
When you decide to put your money in risky investments you run the possibility of:
- Losing your hard-earned money
- Liquidity risk- Not being able to convert your investment to cash when you need to exit the market
- Being charged higher fees and other costs that reduce the net return
There will always be some risk involved when you opt to invest. It is therefore important to do a risk assessment before selecting any investment.
There are different securities in the market and all have different risk profiles. The main securities available in the market are mutual funds, bonds, and stocks. Other vehicles include alternative investments like real estate and derivatives. All these carry different levels of risks with some being riskier than others. The risk profiles of these vehicles include:
- Bonds: In simple terms, a bond is a loan made by an investor to a borrower (Corporates or governments). Bonds are typically less risky (though not all times) than stocks because they preserve your principal investment.
- Mutual Funds: They are a pool of funds collected from investors to invest in securities like bonds, stocks, and money market. Mutual funds can be a hybrid of stocks and fixed income papers like balanced fund and others like money market funds that invest in low-risk investments. Money markets preserve your principal amount and earn you interest while equity funds are riskier with the potential of earning higher returns.
- Stocks: It basically buying into a company, this can be public traded companies or private that you buy over the counter. Stocks tend to have higher returns than less risky investments like money market funds. You need to be cautious with stocks because there is the risk of losing your principal amount.
It is important to find the level of risk you are comfortable with when constructing your investment strategy. It is personal for each investor and different factors contribute to the amount of risk you can take on and the willingness to take on additional risk.
Always remember that being too conservative in your investment may lead to you not meeting your financial goals and taking on a high degree of risk that has the potential to earn high return may lead to you losing your money.
It is therefore important to build your portfolio and expectations around your risk comfort level. Financial advisors can help you in assessing your risk profile and in the selection of securities that suit your risk profile and always remember to not put all your eggs in one basket.
Written by Caroline Musau, Chief Operating Officer at Vasili Africa. Get in touch with Caroline for free investment advice via info@vasiliafrica.com or fill in the form below.
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