All investments have some risk, but the right amount of risk can help you increase your investment return over time. Learn about key investing topics like rebalancing and asset allocation.
The risk-reward ratio describes an investment’s potential loss compared to its potential gain. Investments with lower capital risks – such as bonds – typically offer higher returns than those that are more volatile – such as shares.
Diversification
Diversification is the practice of spreading your investment dollars across a wide range of assets to reduce risk. This allows your investments to benefit from growth periods even when others are declining, and may also limit the overall impact of losses on your portfolio.
It is a common concept familiar to most of us from the phrase “don’t put all your eggs in one basket.” The same applies when it comes to investing. If you invest in only stocks and the market drops, your holdings could lose value quickly. However, if you diversify your investments and one loses value, your other investments will offset the losses.
There is a risk that all investors face that cannot be eliminated or reduced by diversification, known as systematic or market risk. This includes factors like inflation, exchange rates, war, interest rates, and political instability. A financial advisor can help you understand these risks and how they affect your potential for gains and losses.
Time horizon
The time horizon you choose for your investments determines how much risk you can afford to take. The longer your investment horizon, the more aggressive you can be with riskier assets. This is because you have more time to recover from potential losses.
Investors with shorter investment horizons tend to choose safer assets, such as savings accounts and CDs. These investments may not produce high returns, but they are less likely to lose value from market fluctuations.
Investors who have only a few years to go before their financial goal is funded must carefully consider their tolerance for volatility. They cannot afford to lose a significant amount of their principal due to market setbacks. They must also factor in inflation, which can reduce the purchasing power of their money. As their funding date approaches, they will usually shift their portfolio toward more conservative assets. These might include bonds, cash and other fixed income securities. They will often exclude more volatile assets, such as stocks and exchange-traded funds.
Insurance
Insurance is a risk transfer mechanism that provides compensation to policyholders in the event of loss. It is typically used to compensate for losses caused by unexpected events, such as floods or earthquakes. Insurance is also a way to hedge against the risk of losing money on investments. Insurance companies often use short-term assets to invest their premiums, which generates interest income while they wait for potential payouts.
In wealthy countries, the evidence suggests that indemnity-based insurance does not encourage risk reduction practices and may even provide disincentives (Morris and Heltberg 2011). However, some experts argue that major design changes are needed to promote disaster resilience through insurance.
A growing number of parametric micro-insurance programs target resource-poor clients in developing countries. These programs offer the potential to foster risk reduction through the use of a variety of interventions, including subsidies and other forms of support that make insurance affordable for poor clients. In addition, these interventions can help to address moral hazard.
