Understanding risk-reward in investments

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One of the most fundamental rules in investment is the trade-off between risk and returns. Generally, the higher the returns, the higher the risk.

A common way to measure investment risk is “standard deviation”, which measures the price or returns volatility of assets such as stocks, bonds, and unit trusts. The higher the volatility, the greater the likelihood of losing money on that investment.

Understand your risk profile before investing. This can be influenced by factors such as your age, how much emergency savings you have, investment experience, and risk appetite.

Diversification is one way of managing investment risk.

One of the most fundamental rules in investment is the trade-off between risk and returns. Generally, the higher the returns, the higher the risk.

Put simply, it is about the risk of loss on your investment. A common measure of investment risk is “standard deviation”, which looks at the variability of the annual rate of return of any investment.

In technical terms, standard deviation measures the “dispersion of a data set relative to its mean”. In simpler terms, it measures what is commonly referred to as the price or returns “volatility” of any asset: stocks, bonds, unit trusts, etc.

The greater that volatility of returns, the greater the likelihood of you losing money on your investment, particularly over shorter time frames.

Data for US stocks, corporate bonds and Treasury bills over a 90-year period from 1926 to 2015, published by US investment adviser Ronald Surz, shows the relationship between risk and returns:

  • Treasury bills (US government bonds) had the lowest risk, with standard deviation of 0.89. But it also had the lowest returns of 3.46% per annum (p.a.).
  • Corporate bonds had higher returns of 6.08% p.a., but their standard deviation went up to 7.28.
  • Stocks had the highest returns of 10.02%. Their standard deviation was also the highest at 18.85.

But note that even within each asset class, there are different levels of risk associated with individual securities. For example, a government bond issued by a AAA-rated country is lower risk than one issued by a BB- country. As a reference, Singapore has a AAA rating, the highest rating, from ratings agency Standard & Poor’s. And hence the Singapore Savings Bond (SSB), which is issued and backed by the Singapore government, is one of the safest investments around.

And within corporate bonds, the probability of default—defined as the inability of the issuer to repay the interest on the bond—has been found to rise as the credit rating of the issuer declines.

For equities, the risks vary between individual stocks and between different groups of stocks. Such risks can also be measured by the standard deviation method. For example, emerging market stocks typically have a higher long-term standard deviation than developed market stocks.

As mentioned, investors generally have to take more risk to get higher returns. Yes, there is a risk of loss, particularly over short time frames. But being overly conservative also poses a risk. For example, not investing or investing in very low-risk products may result in your savings devaluing through inflation.

It is important to understand your own risk profile before investing. Your risk profile may be influenced by your:

  • Age – The younger you are, the more time you have to ride through market volatility, and hence the greater your ability to take risk.
  • Savings – How much you have already set aside for emergencies is another factor. The greater the financial “buffer” you have, the higher your ability to take risks.
  • Investment knowledge or experience – The more knowledgeable you are, the better you can handle complex financial instruments. And the more experienced you are, the likelier you can stomach market volatility.
  • Risk appetite – This is the sum of your circumstances, personality, and preferences. And it comes down to how much loss you can tolerate on your investments.

Diversification is one way of managing risk.

First, there is stock diversification, where you reduce single stock risk by having a portfolio of stocks. A popular practice is to keep any single stock to no more than 5% of your portfolio. That way, even a total loss in one stock would be merely painful rather than catastrophic. That suggests a portfolio of at least 20 stocks.

Then there is asset class diversification. Having a portfolio of 20 stocks would not save you from broad market risk. So, seek asset class diversification through, for example, real estate investment trusts, bonds and alternative assets such as commodities (which you can gain exposure to via unit trusts or exchange traded funds). By having different assets with different returns and cyclical characteristics, you can cushion yourself from some of the bumps of market volatility in any single asset class.

Another way of managing risk is “time in market”. This means staying invested over the long term, even as markets fluctuate. Research has found that the longer the investment time frame, the lower the risk of incurring losses in your stock holdings.

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