There is a trade off between risk and return. Anyone who tells you any different is lying. If I had a dollar, for every time a client told me about a no risk investment returning a guaranteed 20%, I would be on a beach somewhere, right now. My advice is always the same, it is highly likely you are being scammed, run!
Remember risk is the chance that an investment won’t give you the return you expect. It is the chance of losing some or even all of your investment. Higher risk investments are generally associated with higher potential returns. Low risk investments are generally associated with lower potential returns. This is the risk/return trade off. No one in their right mind would take on a high risk investment for a low potential return. It makes no sense, the return you get at the end of the day does not compensate you for the high probability that you will lose your money. A low risk investment doesn’t need to offer a big return because it is unlikely you will lose you money. Markets all day, everyday are pricing risk.
So, why do so many people get scammed? It is human nature to focus on the outcome, the big return rather than the risk involved. People want to believe that high return investments, exist without risk, but I guarantee (after 16 years in the industry) they do not. If someone tells you they do, then they are either lying to you or they do not fully understand the risks involved in the investment. Too much of a focus on return and not enough on risk, was the downfall of many an investor during the global financial crisis (GFC).
In general, cash is considered the lowest risk investment. The cash rate set by the Reserve Bank is called by the industry the “risk free” rate. So if something has a return close to the cash rate, which is currently 3%, it “should” be relatively low risk, although you still need to understand the exact nature of the investment to be sure. On the other end of the scale, I consider a 15% return from the share market to be a very good return. According to the ASX, the Australian share market has averaged 9.3% over the last twenty years to 31 December 2012. Shares are considered one of the higher risk investment types (more on this next week). Anyone guaranteeing investment returns anywhere in the double digit range are to be viewed with great caution. I’m not saying you can’t make double digit returns – it is just that is it is highly unlikely to be guaranteed (ie. low risk), especially in the current low interest rate environment.
The key is to always focus on the risk involved in any investment and to make sure that the potential return makes sense given the risk. The only way to truly understand how much risk you are taking in an investment is to understand exactly where and how your money is being invested. This should be done for each and every investment that you make.
Gearing or borrowing to invest always increases risk, as well as potential return. I am quite a conservative investor so my golden rule is to never put your family home at risk when investing. For me it is a risk not worth taking. Many people have lost their family homes in investments gone bad, when they never really understood the level of risk they were taking, or were scammed by the offer of generous returns.
Next week we are going to start going through the different investment types or asset classes as they are known in the industry. We are going to look at their key characteristics and where they sit when it comes to risk and return.
If you liked this post check out the rest of the series by clicking on the links below:
* Please note this is for your general information only and does not constitute financial advice.