All about risk and return
DANIEL BUENAS explains the two basic concepts that are central to all investment decisions
LAST week we talked about investment time horizons. This week, we'll look into the basic concept of risks and return, which are primary considerations if you want to invest. While this may seem like something which is common sense, it is important that you have a good understanding of this concept before you start investing. After all, risk and returns are likely to form the basis of all your investment decisions.
WHAT ARE RETURNS?
This is basically what you gain (a positive return) or lose (a negative return) on your investment, after you have cashed out on it. Even if you have not actually sold your investment, you can still calculate your return by comparing your investment's market value against your purchase price.
There are usually two different ways you get returns from your investment.
# The first is through interest or dividend payments in cash, which is also called income. When your income is expressed as a percentage of the purchase price, you get what is known as yield.
# The second type of return is through appreciation/depreciation in your capital, which is the rise or fall in the value of your investment. This is known as your capital gain, or loss.
You can use annualised returns to compare investments held over different lengths of time. For example, if you had an investment that gave a return of 30 per cent over 3 years, your annualised return would be 9.1 per cent.
Take note though, that you will have to take into account transaction costs and charges when computing your returns, as these will eat into what you actually made. For example, you will incur brokerage charges when you buy or sell shares, and when investing in unit trusts, you will also have to bear management fees and other expenses.
WHAT IS RISK?
Risk can be divided into two basic types:
# The first is systemic risk. These are things that affect the market in general, and include economic conditions, changes in interest rates, changes in market sentiment or shifts in government policies. Basically, systemic risks are things that you are unlikely to escape from, and as an investor, you cannot avoid systemic risks.
# The second type of risk is specific, or non-systemic risk. These are factors that apply only to the investment you hold, including the quality of a company's management and sustainability of its products or services. This type of risks can be reduced if you spread your risks over a number of holdings.
NO PAIN NO GAIN?
As they say, high risk, high returns - for most investments, this adage holds true. A common mistake that investors make is to focus only on the expected return of an investment, without considering the risk.
As an investor, you need to know what your risk tolerance is. To figure this out, you have to look at your cash flow, financial commitments, and your future plans. You also need to look at your investment time horizon (which we discussed last week). Generally speaking, the more time you have, the more risk you can take.
HOW DO I MANAGE RISK?
One of the simplest tools you can use to manage risk is diversification. This means spreading your investments over a variety of assets to avoid too much exposure to a single source of risk.
If you find that you don't have enough resources to diversify your portfolio, or if you think you don't have the expertise to choose different investments from different sectors, the best thing to do is get some professional advice.
In today's markets, where companies can go belly up almost overnight and where events half a world away can cause havoc at home, it's good for you to understand this simple concept of risk and return.
Information for this article was provided by the Monetary Authority of Singapore and the Investment Management Association of Singapore (IMAS) as part of the MoneySENSE national financial education programme.
DANIEL BUENAS explains the two basic concepts that are central to all investment decisions
LAST week we talked about investment time horizons. This week, we'll look into the basic concept of risks and return, which are primary considerations if you want to invest. While this may seem like something which is common sense, it is important that you have a good understanding of this concept before you start investing. After all, risk and returns are likely to form the basis of all your investment decisions.
WHAT ARE RETURNS?
This is basically what you gain (a positive return) or lose (a negative return) on your investment, after you have cashed out on it. Even if you have not actually sold your investment, you can still calculate your return by comparing your investment's market value against your purchase price.
There are usually two different ways you get returns from your investment.
# The first is through interest or dividend payments in cash, which is also called income. When your income is expressed as a percentage of the purchase price, you get what is known as yield.
# The second type of return is through appreciation/depreciation in your capital, which is the rise or fall in the value of your investment. This is known as your capital gain, or loss.
You can use annualised returns to compare investments held over different lengths of time. For example, if you had an investment that gave a return of 30 per cent over 3 years, your annualised return would be 9.1 per cent.
Take note though, that you will have to take into account transaction costs and charges when computing your returns, as these will eat into what you actually made. For example, you will incur brokerage charges when you buy or sell shares, and when investing in unit trusts, you will also have to bear management fees and other expenses.
WHAT IS RISK?
Risk can be divided into two basic types:
# The first is systemic risk. These are things that affect the market in general, and include economic conditions, changes in interest rates, changes in market sentiment or shifts in government policies. Basically, systemic risks are things that you are unlikely to escape from, and as an investor, you cannot avoid systemic risks.
# The second type of risk is specific, or non-systemic risk. These are factors that apply only to the investment you hold, including the quality of a company's management and sustainability of its products or services. This type of risks can be reduced if you spread your risks over a number of holdings.
NO PAIN NO GAIN?
As they say, high risk, high returns - for most investments, this adage holds true. A common mistake that investors make is to focus only on the expected return of an investment, without considering the risk.
As an investor, you need to know what your risk tolerance is. To figure this out, you have to look at your cash flow, financial commitments, and your future plans. You also need to look at your investment time horizon (which we discussed last week). Generally speaking, the more time you have, the more risk you can take.
HOW DO I MANAGE RISK?
One of the simplest tools you can use to manage risk is diversification. This means spreading your investments over a variety of assets to avoid too much exposure to a single source of risk.
If you find that you don't have enough resources to diversify your portfolio, or if you think you don't have the expertise to choose different investments from different sectors, the best thing to do is get some professional advice.
In today's markets, where companies can go belly up almost overnight and where events half a world away can cause havoc at home, it's good for you to understand this simple concept of risk and return.
Information for this article was provided by the Monetary Authority of Singapore and the Investment Management Association of Singapore (IMAS) as part of the MoneySENSE national financial education programme.
