Should I accept Higher Risk to accept higher potential returns

3 December 2016
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3 December 2016, Comments 0

In a previous topic we discussed if you should be careful of protecting loss to your capital. Now let us focus on whether it makes sense to accept higher risk in order to achieve higher potential returns. Actually these two topics are two sides of the same coin and much of the debate will depend on which side you are on.

Risk vs Return

It is often said that if you take high risk you are doing this because you are seeking a higher return. If you want to play it safe you can go for a lower risk product but the returns will be lower too. Your choice will be guided by your circumstances ad risk profile

Time Horizon

Again this plays an important factor. The younger you are the longer your time horizon will be because you will have many more years to retirement than an older person.  This is very obvious but worth pointing out. If you have more time on your side, then you can ride out the volatility in the value of your investments so that even if it drops in the short term, you can wait until the recovery happens in the long term because you are taking a very long term view. So if you are young, time is on your side and you can afford to take the risks mores o than an older person.

Risk Profile

As discussed before, there are three main classes of risk profile:

  1. Risk taker – the individual who seeks a higher return and accepts the fact that they have investments that are more volatile
  2. Risk aversion – the individual who does not want to take unnecessary risk and prefers a product that will not drop in value
  3. Risk neutral – the individual that is medium risk taker and has a balanced outlook

Risk Assessment

In order to know which risk profile suits an individual it is necessary to go through the process of risk assessment to identify the risk appetite. Once you have done this and if you are a risk taker, the professional financial advisor will be able to discuss products that are suited to your profile

In the previous example we compared and contrasted an individual in their 30’s and another in their late 50’s. Whereas the person in the late 50’s is nearing retirement age, it would not be appropriate to suggest high risk products as a lower risk product may be better for their investment needs. On the other hand, the person in their 30’s has many years to go before reaching retirement and there is time to make up for any short term losses due to volatility in price

should-i-accept-higher-risk-to-accept-higher-potential-returns

Types of products that can be considered

Equities

Equities are shares in companies and many people like to play with such securities. While equities is one product class, there are many different types of equity with different levels of risk. For example if you want to invest in a safe equity, you may choose a blue chip company that is listed on a main stock exchange. An example would be Apple share. Something safe.

If you want equity that has a higher potential return but carries risk of not giving you any return whatsoever and maybe even a loss you can think about investing in a company that is exploring for a valuable commodity. Eg an oil exploration company or diamond mining company. Such a company will be searching for something and burning a lot of cash in the process. They will not have any value until they find what they are looking for but when that happens the values will increase significantly. This is your return.

Derivatives

Derivatives are instruments whose values are derived from an underlying asset. It can be an option on an equity and such options can be put options or call options. If you buy an option you will pay a premium for the option that gives you the right to either buy or sell the equity at a given price which is called the strike price. The reason why this is considered high risk is that it is a highly leveraged product. You can either lose everything because the option is worthless and the option expires and never makes you money or the option can be valuable because the underlying asset price moved in the direction you wanted and the small premium you paid has now paid off handsomely. If you choose to trade in derivatives it is advisable to research the instrument properly so you fully understand the risk and rewards

Summary

If your risk assessment shows that you are prepared to accept higher risk in return for a higher potential return, then by all means search for such products. It is strongly advised that you search for your own professional financial advisor who can guide you in your decision making. The article in my websites are general in nature and does not apply to everyone. No liability is accepted whatsoever for any losses suffered by the reader.

 

 

 

 

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