Understanding investment risk and return is essential for all investors. One of the key principles of investment management is, rational investors are risk-averse. This means all other things being equal a rational investor will opt for the lower risk option where returns are the same.
When investing, always ask 3 questions: what is the potential upside? What is the potential downside? Am I able to accept the potential downside?
Investment is about understanding and managing risk, not avoiding it altogether.
Each of the 4 building blocks of a portfolio has its own risks, the following are examples of risks and the asset classes long term returns:
Cash is subject to inflation risk over the long term. This means an investor will be able to buy fewer goods and services with the money due to the erosion of inflation over time. Between 1926 and 2016 the inflation-adjusted annual return on cash was 0.50% (source: Ibbotson & Associates)
Risks commonly associated with Fixed Income are a default and reinvestment risk. Default risk is the failure of the borrower to pay interest or repay the capital when the loan expires. Reinvestment risk relates to the possibility of not being able to reinvest the income received at the same rate as the original capital. This results in a variation of return which may be higher or lower than expected. Between 1926 and 2016 the inflation-adjusted annual return on US Treasuries was 2.6% (source: Ibbotson & Associates)
Property is generally illiquid, suffers from fluctuations in value, regulatory risk and void periods. Liquidity is a desirable attribute for investors. This is because it enables them to use their money for other purposes. Letting of residential property is subject to strict regulatory oversight in many jurisdictions and a significant tax burden. No long-term return data to be found.
Equities/Shares represent partial ownership of a company. They have a high degree of liquidity and are the most volatile of the basic asset classes. This means their value can swing widely over a short period of time. Many shares generate income in the form of dividends. Dividends are not guaranteed and are largely dependent on company profits and managerial discretion. Between 1926 and 2016 the inflation-adjusted annual return on US shares was 6.9% (source: Ibbotson & Associates)
Investment risk and return are related. These long-term returns show what a realistic return on investments may be going forward for a given level of risk. Always be sure to identify the risk before investing. If it looks too good to be true, it probably is.
What Should I Do Next?
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