Risk versus return

Understanding the investment basics

It's important to understand a few investment basics before you start to invest. Three major things to be aware of are:

• the different types of investments and how they perform
• the relationship between risk and return
• why diversification is essential for a sound investment strategy

This page covers the relationship between risk and return.

All investments provide a certain level of return and are subject to a certain level of risk. Basically this means that as well as making money on your investment there's also a chance you could either lose money or not make as much as you expected.

As a general rule, the larger the potential investment return, the higher the investment risk, and the longer you need to remain invested to reduce that risk.

This chart shows the various types of investments and where they sit on the risk and return spectrum. Cash provides lower returns and has lower risk of loss, while overseas shares provide higher returns but they also carry a higher risk of loss.

How to manage investment risk

The amount of risk involved with an investment can be managed by matching it appropriately with the length of time you have available to invest and your tolerance toward fluctuations in returns.

For example, if you are saving for a house deposit and have only 12 months to go before you reach your goal, you would probably be unwilling to risk losing any of that money – it would make sense to avoid investing it in growth investments and consider income investments instead. If, however, you're investing your superannuation and you're not retiring for 15 years, you could ride out any short term losses in growth markets in order to achieve potentially higher returns over time.

All investments involve some level of risk. Even if you choose the least risky investment, cash could still run the risk of inflation eroding the value of your capital, which means your money will buy less as time goes by, or falling interest rates which will reduce the level of your return.

It's tempting, for retirees in particular, to use defensive investments exclusively when you're worried about maintaining the security of your capital over a long period. However, unless you include a proportion of growth investments with those defensive investments, you could likely find that you're appreciably worse off five or ten years down the track, struggling to make your income stretch as far as it once did. Learn more about growth investments.

As you can see, the amount of time you have available to invest makes a significant impact on your true level of investment risk.

Apart from considering your investment timeframe, another effective way to manage investment risk is to consider spreading your money across various types of investments rather than relying on just one type of investment to meet your goals. This is called diversification and it is a strategy that is commonly used to reduce risk.

Your tolerance for investment risk

When selecting your investments, along with considering your investment timeframe it's also important to reflect on your own personal tolerance level for investment risk. You need to make sure you'll feel comfortable with the amount of risk you're taking and the potential consequences of your investment decisions.

Some people can remain relaxed while their account balance fluctuates wildly, while others are nervous if their account shows even the tiniest drop in value.  If you're going to be awake at night worrying about your investments, no matter what returns you earn they're not likely to be worth the personal cost.

There are many factors which affect your level of tolerance for investment risk:

• Your reasons for investing
• Your performance expectations
• How long you intend to invest (timeframe)
• Your knowledge of investment markets and past experiences
• How you feel about sudden increases and decreases in the value of your investments

 

Keep in mind that your tolerance for investment risk may change as you gain investing experience and confidence.

Seek advice on the investments that will suit you

Whether you're an expert or novice investor, good advice is important. Commonwealth Financial Planners specialise in helping you make the right investment decisions. A Commonwealth Financial Planner will explain the risks of various investments and help you determine your tolerance for risk. They will then work with you to develop an appropriate financial plan designed to achieve your personal financial goals.

To find out more about how a Commonwealth Financial Planner may be able to help you, or to make an obligation-free appointment with a Commonwealth Financial Planner call 1800 241 996 or email us.

Important information

• This is not advice, this provides general information only and does not take into account your individual financial circumstances or investment objectives. You should assess whether the information is appropriate for you and consider talking to a financial adviser before making an investment. Investment products are subject to investment risk including the loss of income and capital invested. Colonial First State Managed Investment Funds, FirstChoice Investments and FirstChoice Wholesale Investments are issued by Colonial First State Investments Limited ABN 98 002 348 352 AFSL 232468. Product Disclosure Statements (PDSs) describing the products are available by contacting Investor Services on 13 13 36. You should consider the relevant PDS before making a decision about the product. The responsible entity, Colonial First State Investments Limited receives fees.
• Commonwealth Financial Planners are representatives of Commonwealth Financial Planning Limited ABN 65 003 900 169 AFSL 231139. Commonwealth Financial Planning Limited is a wholly owned but non-guaranteed subsidiary of Commonwealth Bank of Australia ABN 48 123 123 124.