Every investor, whether a professional fund manager or individual, seeks capital appreciation when buying assets. However, as we have witnessed in the past few years, there are two sides to investing.
Unfortunately many are caught off guard when the markets turn on them. The consequences of not managing investment risk can become severe.
When developing and implementing a financial plan, its critical that you consider the risks in each investment you make. The goal of financial planning is to enable you to live the life you want to live. In-order to accomplish this you must consider the relationship between the risks and returns of investing.
Measuring the Returns of Investing
In light of the fact that all investors seek returns on their capital, it’s obvious that they would also prefer the highest return possible. Due to market forces, the securities with the highest risk usually come with the highest potential return. On the other hand, the securities with the lowest risk, usually have the lowest returns.
The expected returns of assets are usually calculated two ways. For basic analysis the investor will assume that historical trends will continue, thus if a stock has returned an average of 12% annually it can be expected that it will return 12% a year in the future.
Advanced analysis takes many more variables into consideration than simply the historical average return. Equity analysts will take into account expected earnings, valuation, macroeconomic, business and industry related factors in-order to estimate the future returns of an investment.
Measuring the Risks of Investing
As mentioned above, there are a multitude of risks to consider when investing. Some risks are inherent to specific asset classes. Other risks will affect all asset class, if only to varying degrees.
Systemic risk affects all asset classes and can be described as the risk inherent in the financial system as a whole. This type of investment risk includes “market risk” and “political risk”. Think of this in terms of the macro-economy, if the entire country falls into recession all stocks will be affected. On the other hand, non-systemic risk only affects particular securities, businesses or sectors.
The expected risks of investments can be quantitatively measured through the calculation of standard deviation. Calculating the standard deviation of an asset measures it’s historical variation from its average price. This also can be described as the asset’s volatility. Usually, large-cap stocks have the lowest risk and small-cap stocks have the highest.
Before you invest your hard-earned money, ensure that you understand how to measure the risk and returns of different investments. When understanding the risk-reward relationships of your assets, you will be able to create better portfolios.