Balancing Risk and Reward in Your Portfolio
Investment risk is tightly linked to return. Not taking on sufficient investment risk can expose investors to other risks. This article looks at achieving the right balance. It includes a case study to explain.
If you own an investment property you will be aware that the return from the investment comes from two sources: income in the form of rent paid by the tenant and growth in the form of an increase in the value of the property while you own it. Likewise from a share investment, an investor can receive dividends (income) and capital gain (growth).
Many investors who buy shares and property focus on the growth potential with income being a beneficial addition. On the other hand, investments such as term deposits and bonds have as their main attraction the income return, with little or sometimes no possibility of capital growth.
Understanding risk and return
When investing, risk is best thought of as uncertainty. For example, with a term deposit in a major bank we can predict with a high level of certainty what our return will be, and it is extremely unlikely that we will lose money. The level of risk is very low, but these days returns on term deposits are equally low.
Contrast that situation with shares. If we buy a share today we can’t be certain what its value will be in a year’s time. Because the return from shares is uncertain, they are considered higher risk.
That doesn’t mean shares are a bad investment. On the contrary, patient investors have been well compensated for taking on this risk. Property and shares are higher risk, but over the long term they have produced the highest returns. Cash and bonds are lower risk and produce lower returns.
Investors also need to take into account the risk of not achieving their goals. Generally, avoiding investment risk means retirement savings won’t grow as much, and won’t last as long as would have been the case if a higher level of growth had been sought.
Take this example…
Twin brothers
John and Robert are twins. They both start the same type of job on the same day and each receives superannuation contributions of $6,000 a year*. John is a conservative investor, and his fund returns 6% pa after inflation. Robert wants more growth. He accepts this is riskier and his returns fluctuate more than John’s. Even so, Robert’s fund provides an average return of 8% a year.
How much will they have?
A 2% performance difference may not seem like much, but look at its effect over time. When they retire after 35 years, John and Robert each have:
| John | Robert |
| $668,609 | $1,033,900 |
And how long will it last?
When they retire, John and Robert decide to take a pension of $46,000 and $88,000 a year from their respective super funds. They both keep their investment strategy in place, with the same average earnings. The following table shows the number of years before each runs out of money.
| John | Robert |
| 35 years | 35 years |
John’s portfolio produced consistent returns over the years. The performance from Robert’s portfolio was a bit more variable. But by accepting a little more investment risk, Robert can enjoy his retirement drawing almost twice as much annual pension as John.
Understanding risk
In putting together a suitable portfolio for a client, financial advisers will seek to achieve an appropriate balance of “growth” and “income” assets.
Talk to us about your investment needs and what suits you best.
*All calculations and investment returns are after fees, tax and inflation.
