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Broadly defined as exposure to danger, the word ‘risk’ often has negative connotations. A less emotive description would be that it simply means ‘the ability to measure or predict objective outcomes.’ For investors, risk is the chance that a particular outcome or financial gain differs from its expected outcome or return. Yet it is important to realise that risk is an inherent part of investing and shares a fundamental relationship with returns: the more risk an investor is prepared to take, the greater the level of potential returns. There are different types of financial risk that may prevent investors from reaching their financial goals. We have listed some of these below:
While there is a positive correlation between risk and return, a desired level of returns cannot be guaranteed. Risk exposure is therefore a trade-off to be viewed against the backdrop of an investor’s wider financial circumstances, and will depend on a range of factors, including their investment
timeline/horizon and desired level of risk tolerance.
Taking on higher levels of risk to generate higher returns can potentially lead investors to lose wealth that they can’t afford. A broad rule-of-thumb suggests that investors should invest no more than 10% of their net assets (i.e. total investments excluding one’s primary home) in high risk investments which could be lost. Conversely, too little risk and an investor’s goals may not be achieved.
While all investors have their own specific resources and goals, one way of determining a risk-reward framework is to use an investment risk pyramid. Divided into three segments, the bulk of assets would be at the base layer and allocated to lower risk investments. As the pyramid narrows, so investment selection shrinks and becomes riskier.
Occupying the top of the investment pyramid, holdings here represent the high risk/high reward options. While offering the possibility of outsized returns, their elevated risk profile – possibly comprising derivatives, commodities and cryptocurrencies - means that investors should be able to accept losses here with few repercussions to their longer term goals.
Including blue chip stocks, unit trusts, real estate and index trackers, this blend of slightly more risky assets offers the possibility of higher returns, while providing protection against weakness for a particular stock or asset.
Examples of financial assets in this category might include savings accounts and government bonds. These risk averse instruments provide capital preservation and an income stream.
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