As participants in the investing world, we are constantly in pursuit of higher returns. However, when placing our hard-earned money into financial assets, we must be comfortable with the chosen risk profile and objective of the investment. There are two distinct investor types: those who are financially and emotionally able to handle higher levels of risk and others who are intolerant to risk. Our attitude towards risk is referred to ‘risk aversion’ and it varies from one investor to another. The level of risk aversion depends on a variety of factors, most importantly, on goals, level of income, life-stage and financial knowledge. A trusted financial advisor helps investors to identify assets that meet their risk profile and investment objective.
Risk is defined as the probability that an investment’s actual return will differ from what was originally expected. The risk-return relationship is simple: low levels of risk are generally associated with low potential returns and high levels of risk are associated with high potential risk. The keyword here is potential. The risk-return trade-off does not guarantee that higher risks translate into higher returns. There is only a possibility. Investors require higher returns from riskier investments simply because they must be induced with a good enough risk premium for them to trust their money within these assets. If the return on Malta Government paper was the same as the return on local corporate bonds, investors would simply flock into Malta Government bonds which are usually positioned on the low side of the risk spectrum.
Diversification is a technique which aims to reduce risk through a wide variety of investments within the same portfolio thereby protecting capital. To ensure the best diversification, a portfolio must include exposure to multiple investment vehicles and varying investment exposures to, economies, industries and asset classes. Investments in collective investment schemes are an economical way for retail investors with relatively small amounts of money to obtain the same level of professional management and diversification of investments, as wealthy individuals and financial institutions.
The Business Observer, 27th August 2015