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The relationship between risk and reward is a fundamental principle of investing. The higher the risk, the higher the potential reward, but also the higher the potential loss.

The biggest risk to your savings is not taking on any risk. To prevent your wealth declining in real terms (after inflation), your investments need to grow above inflation after deducting tax. Over time this can only be achieved by taking on some risk, i.e. by having a portion of your savings invested in risk assets, such as equities (shares), property or bonds.

In this article, we’ll explore the importance of understanding risk, finding the right risk strategy, and why taking no risk is the biggest risk of all.

 

The relationship between Risk and Reward

The relationship between risk and reward is often depicted as a trade-off. If you want a higher potential return on your investment, you must be willing to accept a higher level of risk. Conversely, if you want to minimize risk, you may have to settle for a lower potential return. This trade-off is true across all types of investments, including stocks, bonds, and property.

For example, stocks are generally considered riskier than bonds. Stocks can be volatile, and their value can fluctuate dramatically in response to market conditions. However, stocks also offer the potential for higher returns than bonds. Over the last 10 years, the Johannesburg Stock Exchange (JSE) has produced average annual returns of around 10% and bonds around 6-7%. Of course, these averages don’t guarantee future returns, and it’s important to remember that past performance is not necessarily indicative of future results.

The chart below compares the 10-year performance of Investonline’s ‘Aggressive’, ‘Moderate’ and ‘Conservative’ risk portfolios. Note the outperformance of the Aggressive portfolio, but with greater price fluctuations (volatility) along the way.

Risks Can Be Managed

Risks can be managed, but they cannot be eliminated. Even the safest investments carry some level of risk, and it’s important to be aware of this. Some mitigating risk management strategies can include diversification, asset allocation, and periodic rebalancing.

Diversification means spreading your investments across a range of different asset classes, sectors, and geographies. For example, if you invest only in one stock and that stock performs poorly, your entire portfolio will suffer. But if you invest in a diversified portfolio of stocks, bonds, and other assets, the poor performance of one investment may be offset by the positive performance of others.

Asset allocation refers to the percentage of your portfolio that you allocate to different asset classes, which carry different levels of risk. The allocation will depend on your individual financial goals, investment timeline, and risk tolerance. A more aggressive investor may choose to allocate a larger percentage of their portfolio to stocks, while a more conservative investor may choose to allocate a larger percentage to less risky assets, such as bonds and cash.

Rebalancing involves periodically adjusting your portfolio to maintain your desired asset allocation. For example, if your stocks have performed well and now make up a larger percentage of your portfolio than you intended, you may need to sell some stocks and buy more bonds to bring your portfolio back into balance.

As unit trusts invest in a broad range of assets, it can help to reduce the impact of any one investment’s performance on your overall portfolio. For example, if the unit trust invests in a diversified portfolio of stocks and bonds, the poor performance of one stock may be offset by the positive performance of other stocks or bonds held by the fund. There are hundreds of unit trusts available in South Africa, each with its own unique investment risk mandate.

Taking No Risk is the Biggest Risk

Taking no risk is actually the biggest risk of all. If you keep all your money in cash, you’re essentially guaranteeing that your investment will lose value over time due to inflation. Inflation is the rate at which the cost of goods and services increases over time. In South Africa, inflation has averaged around 5% per year for the last 10 years. This means that if you keep all of your money in cash, your purchasing power will decrease over time.

The key is to find the right balance between risk, reward, and the amount of risk you can tolerate. This should involve diversifying your portfolio across a mix of asset classes, such as stocks, bonds, cash, and property.

The chart below compares five risk strategies, from ‘Conservative’ to ‘Aggressive’. It shows returns from the best year, the worst year, and the average yearly return for each risk strategy:

 

The Prosperity Fund produces steady, inflation-beating returns

The Prosperity IP Worldwide Flexible Fund, managed by Investonline Director Nick Brummer, is actively managed with a conservative risk bias. By way of conscientious risk management, impressive risk-adjusted returns have been achieved, demonstrating Investonline’s ability to effectively manage risk.

 

 

 

The chart below provides a risk analysis report with Prosperity, the JSE All Share and the World Wide Flexible Multi Asset Index benchmarks over the last 5 years.

Per the chart, it’s important to note that the further a fund moves right on the bottom axis the more volatility the fund experienced over the time period. Managing volatility and risk is also crucially important when withdrawing income from your investments during retirement.

 

 

The Right Risk Strategy is Personal

Each investor has different goals, circumstances, and emotional dispositions towards investment risk. The right risk strategy will depend on:

• The risk required to achieve your goals
• Your risk appetite, in terms of your attitude towards investment risk
• Your risk tolerance, in terms of the amount of risk you can afford to take

 

Speak to one of our Client Portfolio Managers to help establish the most suitable risk strategy for you.