The risk versus reward theory

May 24, 2009
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, NAIROBI, Kenya, May 27 – The concepts of risk and reward are probably the most often mentioned when it comes to investing.  All investments involve some degree of risk.

If you intend to purchases securities such as stocks, bonds, or mutual funds – it’s important that you understand before you invest that you could lose some or all of your money.

The reward for taking on risk is the potential for a greater investment return. If you have a financial goal with a long time horizon, you are likely to make more money by carefully investing in asset categories with greater risk, like stocks or bonds, rather than restricting your investments to assets with less risk, like cash equivalents.

On the other hand, investing solely in cash investments may be appropriate for short-term financial goals.

The concept of risk and reward shows the importance of making the right investment choices. Every investor wants to get a substantial return on their investments. By diversifying their portfolio with investments of various degrees of risk, investors may take advantage of a rising market and protect themselves from dramatic losses in a down market.

Many investors find that a modest amount of risk in their portfolio is an acceptable way to increase the potential of achieving their financial goals. However, the basic rule in investment is “the higher the risk, the higher the potential return.”

Investments in cash usually carry the lowest risk. Bonds are usually regarded as having a substantial exposure to risk while equities have the greatest risk. However, history has shown that investment in equities over time has the highest potential return thus supporting the rule of thumb above.

Investors need to understand where their comfort levels are before gauging the risk of their investment. Some investors are willing to take lower levels of risk while others have no objections to taking higher risks.

While most investors are always keen to know how likely they are to lose money, it is more important to make other considerations such as:

    Are my investments going to lose money? (Is safety of principal more important than growth?)
    Will I achieve my investment goal? (university education planning or retirement planning for example).
    Am I willing to accept more risk to achieve higher returns?

The most common investor concern is whether they will lose money. By making investments that guarantee that you won’t lose money however, you will be giving up most of the opportunity to earn a return in exchange.

For example some investors would rather invest in fixed interest and cash equivalents. However, the price for this safety is a very low return on your investment. When the effects of inflation on your investment and the taxes paid on the earnings are considered , their investments may return very little in real growth.

The second consideration when investing is whether the investor will achieve their investment goals. Typically, the factors that will determine whether the investor achieves these goals are:
 
    Amount invested
    Duration or the length of time invested
    Rate of return or growth
    Investment costs for example transaction, legal or investment advisory fees, taxes, inflation, etc.

For investors who cannot accept much risk, then they will earn a lower return on their investments. To compensate for this, they will have to increase the amount invested and the length of time invested.

The question most investors ask themselves is “am I willing to accept higher risk?” Every investor needs to find his or her comfort level with risk and construct an investment strategy around that level.

A portfolio that carries a significant degree of risk may have the potential for outstanding returns, but it also may fail dramatically. The choice of the risk you are willing to take is a personal decision. However you need to find a reasonable mix where you are able to achieve a substantial return to ensure that you are able to achieve your long-term financial objectives. 

In conclusion, investors need to understand that risk is a natural part of investing. Investors need to find their comfort level and build their portfolios and expectations accordingly. An investment advisor should be useful in such situations as experience and knowledge are vital in assisting investors to make the right investment decisions.

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