Record low cash rates have seen many investors forced up the risk spectrum in the search for a greater return. For retirees, this low yielding environment presents a real dilemma. But what does it really mean to take on more risk? What should you be looking out for and how to do you manage risk in the current environment?
To understand the relationship between risk and return, we should accept that the higher the potential return of an investment, the higher the risk. However, there is no guarantee that you will actually get the higher return you are seeking by taking on more risk.
Most of us know that some investments are riskier than others. Government bonds for example are considered low risk – because they are issued by the government. Term deposits are also considered low risk as they are backed by large financial institutions. Whilst you are less likely to lose money with these investments, they have a lower potential return than riskier investments and in some cases may not keep pace with inflation. These types of investments are often referred to as defensive assets.
Shares have potentially higher returns than bonds and term deposits over the longer term but they are also riskier. Shareholders are part owners in a company – a company pays you an income, in the form of a share of its profits (called dividends) and if a company is successful you may see higher dividends and a rising share price (capital growth). However, the downside is that if a company fails you could lose all your money. By investing in a company and taking on more risk, you are hoping to be paid a premium (a higher return) for the risk that you take. Remember that dividends are not guaranteed and if a company needs to improve its balance sheet, dividends may be cut or deferred.
Property is also viewed as a growth investment – that is the capital value of your property investment is expected to grow over time, as well as receiving income from the property (being rent). Shares are property are often referred to as aggressive investments.
There are a number of ways you can manage risk, some include:
Otherwise known as not putting all your eggs in one basket! By spreading your investments over a range of assets classes you naturally manage risk.
Avoid low quality investments
This really comes down to research and can be hard to do, as humans we have bias’s that are complex. Often, we seek out information that can confirm our bias. Getting a second opinion on your investments can help.
Understand your asset allocation
This is the best friend of diversification – what weight will you give to defensive and aggressive investments and how will you monitor this. The recent crisis reminded us all that there are times of market stress where return OF capital can take precedence over return ON capital.
As always we recommend you seek advice to understand your tolerance for investment risk and ensure your investments are aligned.
This information contained in this document has been provided as general advice only. The contents of this document have been prepared without taking account of your personal objectives, financial situation or needs. You should, before making any decision regarding any information, strategies or products mentioned in this document, consult with your GPS Wealth Ltd financial adviser to consider whether it is appropriate having regard to your own objectives, financial situation and needs