Risk Vs Return

While its good to at the first instance, to have assets that provide, a return at par or more than the inflation rate, one cant get wealthy from this. In order, to generate an above-average return, one must take some measure of risk?

How much is enough though? When should one not take the risk?

In personal finance, this is known as the risk vs return choice. The higher the return on an asset, the higher the risk involved. You cant have both at the same time. So if you want very high returns, be prepared to take lots of risks.

Low Risk. Low return

Assets that have the lowest form of risk, have the lowest form of return. Should you decide to simply keep your money under your pillow, its essentially low risk. The only risk being someone stealing the money, or something happening to the house. The downside of this, however, is you get zero interest. If you leave N10,000 beneath your mattress, that’s all you will have.

Medium risk Medium return

Next, on the line, are assets that are moderately risky, but provide a fairly decent return. Assets under this category include treasury bills and bonds.

While they are guaranteed by the government, there is always the risk (though low) that the government can default on its debt.

Returns on these assets are however much better than tucking money under your pillow.

High risk. High return

Assets under this category provide very high returns but are also highly risky. You could end up losing some or all of your capital. Shares fall under this category. Share prices move up and down. A stock could drop massively in price, and remain so for years.

Very high risk. Very high return

Cryptocurrencies are under this category. They are unregulated and offer no compensation in the event of robbery or loss. They also offer a very high rate of return

What type of risk-taker are you?

Now we have looked at the risk vs return profile of various assets, what type of risk personality do you have? Most people can be categorized into one out of the following personalities.

1. Risk avoider

Risk avoiders do not like to take a risk, at all, and will avoid it by every means. They are most likely to keep the bulk of their income in cash. They also prefer investments that have a guaranteed return, and will not bother researching other options. A large proportion of women are risk avoiders.

2. Risk mitigators

Risk mitigators are slightly better than risk avoiders. They tend to do a bit more research on other investments, but still, prefer those with low risk. They are also easily panicked whenever there is a downturn in the market.

3. Risk Manager

Risk managers are the most balanced of the four personalities. While they take quite some risk, they do adequate research before making a decision.

4. Risk embracer

Risk embracers are at the end of personalities. They tend to take part in high risk and high return ventures, and a large proportion of their assets are in such ventures. Risk embracers enjoy the thrill of trading.

How much risk should one take?

Three key factors determine how much risk one can take. They include age, duration and portfolio size.

Age

Age is a key determinant of the amount of risk you can take. The older you are, the less risk you should take. Retirees, for example, are encouraged to have a greater proportion of their portfolio in risk-free and low-risk assets such as bonds and treasury bills.

Young people, on the other hand, can afford to take a sizeable portion of their holdings in risky assets such as equities because they have enough time to walk through the ups and downs.

Duration

Duration is a key factor in determining the amount of risk one can take. It would not make sense for example to invest the funds you are saving towards your house rent, in a risky venture. Your landlord will come calling soon.

On the other hand, you can afford to invest a small proportion of a portfolio devoted to your children’s university education, in a risky asset. (This would, however, apply if your kids have at least 10 years or more to this goal)>

Portfolio size

Portfolio size also determines the amount of risk, one can take. Someone that has just N10,000 can not afford to take any kind of risk. Their portfolio is just too small. An investor with a portfolio size of say N100,000 can afford to take a risk with 10% to 20% of their portfolio.