Diversification: The Risk Leveller

The risk-return trade-off for all investors is the balance between the desire for the lowest possible risk and the highest possible returns.

The risk-return trade-off for all investors is the balance between the desire for the lowest possible risk and the highest possible returns. In general, low levels of risk are associated with low potential returns and high levels of risk are associated with high potential returns.

Every investor has to decide how much risk he or she is willing and able to accept for a desired return. Risk tolerance is usually dependent on a number of factors such as age, income, investment goals, liquidity needs, time frames, and individual personality.

Although the traditional rule of thumb says “the higher the risk, the higher the potential return,” a more accurate statement is, “the higher the risk, the higher the potential return, and the less likely it will achieve the higher return.” 

It is important to keep in mind that higher risk does not automatically equate to higher returns. The risk-return trade-off only indicates that higher risk investments have the possibility of higher returns, but there are no guarantees.

In looking at risk as a spectrum with one side being the high-risk end, the lower-risk side of the spectrum essentially has a risk-free rate of return - the rate of return of an investment with zero risk which represents the interest one would expect from an absolutely risk-free investment over a specific period of time.

Diversification

The most basic and effective strategy for managing and minimizing risk is diversification which itself is based on the concepts of correlation and risk.

A well-diversified portfolio will consist of different types of securities from diverse industries that have varying degrees of risk and correlation with their respective returns.

A number of ways in which investors can plan for and ensure adequate diversification may include:

1: Spreading portfolio among many different investment vehicles such as savings, stocks, bonds, mutual funds, ETFs and other funds. Acquire for assets with different direction and degree of returns.

2: Staying diversified within each type of investment such as having securities that vary by sector, industry, region and market capitalization or on the basis of growth, income, and value.

3: Investing in securities that vary in risk. An investor may also invest in penny stocks and not be restricted to picking only blue-chip stocks as amassing different investments with different rates of return will ensure that large gains offset losses in other areas.

4: Perform regular “check-ups” or rebalancing to make sure their portfolios have a risk level that is not consistent with their financial strategy and goals.

We all face risks every day both in life and in business. Risk in the financial space implies the propensity for an investment’s actual return to differ from what is expected – the possibility that an investment may not perform as investor would expect, or would result in loss.

While most investment experts agree that diversification cannot guarantee against a loss, it is a known fact that it is the most important component to helping an investor reach long-term financial goals, while minimizing risk.

Written by Lawretta Egba