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Understanding risk

Choosing the appropriate level of risk

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.

Investment Risk Pyramid

Summit (high risk)

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.

Middle (medium risk)

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.

Base (low risk)

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.

Starter Guide
to investing

When you’re new to investing, getting started can seem like an uphill struggle. That’s why we decided to create a starter pack to help demystify the process and provide an introduction to the basics.


More articles from our New To Investing mini-series

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