It is of utmost importance for an investor’s portfolio of assets to have the right level of risk. Taking on more risk than is required or tolerable can be deemed as being as bad as not taking on enough in the first place.
Both scenarios can result in insufficient returns, returns that do not commensurate with investment goals, and a lower level of wealth, which would ultimately require a higher savings level.
Choosing the right level of risk involves understanding one’s ability to take on risk, what is known as an investor’s ideal tolerance risk level willingness to take more or less risk than, theoretically speaking, right for him/her. Here we are referring to the risk preference or attitude towards risk. An investor’s attitude towards risk generally determines the type of investments and asset classes to invest in.
A client’s assets relative to the level of risk (and subsequently return; these two go hand in hand) will determine the overall direction of a portfolio, and one should there measure how much quantifiable risk can be measured from a given investment without this risk being a deterrent on portfolio performance and compromising the achievement of the ultimate goal of the investment portfolio.
An investor’s level of safe investments within a portfolio is the key to keeping risk levels at bay and also serves to smoothen out returns, particularly at times of heightened volatility and marked corrections. If a portion of an investor’s total assets are part of a safety buffer, riskier long-term investments can then be added to this base without significant long-term adverse consequences from short-term events. This means that cash and safe assets not only serve as a critical asset class in terms of asset allocation, but also provide an investor with sufficient liquidity to take advantage of market dips.
Another key factor in determining how much risk an investor is willing to, or rather, is in a position to, take on, and is current income, current spending patterns as well as the capacity and trajectory to earn more in the future. Generally speaking, the higher the income, the greater the investor’s ability to cope with risk and, even more important, to respond (via trading activity and trading decisions) to events.
Age and investment horizon are among the fundamental criteria in determining risk tolerance. A long investment period often means you are able to absorb short-term ups and downs. Past investment experience, investor education and personality are all pieces of the jigsaw puzzle when an investor tries to draw up an investment plan and quantify his/her tolerance to risk.
What an investor should be aware of, however, is that some market risks, such as inflation, cannot be avoided. While the short-term ups and downs of the equity market are often the main concern - as it can lead to a low average absolute return - for many, inflation is the key risk when determining a long-term retirement investment plan, for example.
Disclaimer:
This article was issued by Mark Vella, investment manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt.The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.