Who are you?
Are you the kind of person who will be so happy to go skydiving, or are you the kind that will require assistance before climbing a ladder?
If you are happy to skydive, you are a risk lover.
If you are afraid to climb a ladder, you are risk adverse.
The same principle that applies to daily life decisions, also guides financial investments.
In investments, you need to determine your risk appetite. A key question to ask: “will you be able to sleep well at night” with that investment? The risk-return trade-off is best explained as “the ability to sleep well at night test”. Financial securities that yield high returns have high risks associated with them, while those that yield low returns have lower risks.
Financial securities (aka financial instruments or financial assets) are stocks, bonds, treasury bills, and other instruments representing the right to receive future benefits under a set of stated conditions.
Every individual faces a risk-return trade-off while making his/her decision to invest. If you decide to deposit all your money in a savings bank account (which has very low risk), you will earn a low return because in most banks, deposits from customers are protected by insurance. On the other hand, if you decide to invest in stocks (which has high risk), you will earn a high return because your investment in stocks is not guaranteed -- i.e. you can lose all your capital, and you can also gain a whole lot.
To determine an appropriate risk-return trade-off one needs to consider diverse factors such as risk appetite, number of years to retirement, the possibility of regaining lost funds, and very importantly, TIME. An investor’s ability to invest in the stock market over a long-term horizon provides great opportunities for recovery from the risk of bear markets (i.e. when stock prices are falling) and for participation in bull markets (i.e. when stock prices are rising). A short-term horizon makes investment in the stock market is riskier.
The 70/30 principle of asset allocation suggests that an investor who is 30 years old should invest 70% of his/her investment funds in stocks, while an investor who is 70 years old should invest 30% of his/her investment funds in stocks.
In other words, 100 – age = Percentage of investment funds that should go into stocks.
This formula is simple but important because it gives an idea of how the asset allocation of one’s portfolio should change as he/she ages. Some young, aggressive investors may decide to invest 90% or 100% of their funds in stocks, whereas most conservative investors will never own 70% stocks at age 30. The choice is ultimately that of the investor.
It is, therefore, important to reiterate that the higher the risk, the higher the return. Alternatively, the lower the risk, the lower the return. No risk, No return.
Still Craving? Learn more on Investopedia- Risk-Return Tradeoff
Article Credit: Hephzber Ifunanya Nwoka