There is a direct correlation between investment return and investment risk. This means that an expectation of a higher return is always associated with higher risk in that particular investment. While this is a universal fact, it is not something that the investors desire. What investors really desire is highest return at lowest risk, which is actually dependent on the level of risk they are ready to take. Basically, any investor has two main objectives in her or his mind: To increase the capital safely and to obtain a better return than other existing alternatives. More importantly, no investor wishes to be left worried with regards to a significant loss. So, now the question is how an investor can accomplish the final goal of good returns without increasing the risk level.
First, There are Two Concepts to Take Care of!
First is risk that affects the returns and second is diversification that manages risk and aids in fetching better returns.
Exploring the Concept of Risk
Essentially, risk is composed of two gears: Uncertainty and exposure. For example, when you fly in the sky through the sport of paragliding, there is a risk involved. You are exposed to the danger of falling down swiftly if the paraglider fails to operate well. Further, the chances of this accident to happen are uncertain as it is not known in advance which circumstances can put you in danger. However, this risk never stops one from paragliding. Rather, the risk gets assessed and all possible precautions such as emergency training, using safe equipments, and flying only if the weather and wind conditions are favorable. Similarly, investment risk is also the same. Once an investment is done, the investor is exposed to uncertainty of the return not turning to be same as expected. The possible variation of returns is volatility that measures the degree of change in the value of an asset over time (risk). In short, volatility help measures risk. As a generic rule, low-risk assets tend to carry low volatility and vice-versa. However, it is also true that risk is good when properly managed. This is the reason that drives the returns.
Exploring the Concept of Diversification
An ideal investment portfolio needs to feature comprehensive and complete set of clubs for accomplishing investment goals. Herein, the clubs are diverse financial assets such as cash, shares, and property. This blend of assets in a portfolio is diversification and that it tends to vary as per the goal, objectives, risk tolerance level, and time of the investor. Typically, assets are of two types: Income and growth assets. Income assets offer returns on income via coupon and interest payments, while growth assets ensure returns from capital growth over a period of time (property and shares).
Diversification justifies the phrase of avoiding the storage of all eggs in one basket. It helps in alleviating the plus and minus potential for facilitating balanced performance in any kind of economic condition. It is obvious that when you spread your investment in different assets, you are certainly spreading the risk along with it. Now, you may have a question as to how to diversify your risk. Well, a majority of investors prefer diversifying their portfolio by including the ‘core’ assets such as bonds, shares, cash, and property. However, how do you decide the suitable mix of these assets so that you have an optimal portfolio as per your needs as well as circumstances? For determining this, you need a good financial advisor or consultant who can guide you in the right direction efficiently as well as effectively. In this way, diversification can minimize the investment risk smartly.
