Understanding the relationship between risk and return will help you choose the right investments. Generally speaking, investments that have greater investment upside also have greater potential risk.
The simplest way to illustrate this is with examples:
- A bank account is a great example of a low-risk investment. There is very little chance that you will lose your investment. In addition, the value of your investment won't fluctuate wildly (these fluctuations are known as volatility). Your investment will be worth roughly the same each day. The downside is that the potential return from investing your money in a bank account is quite low and may not exceed the reduction in the buying power of your money caused by inflation.
- You could increase your potential return by investing in a term deposit instead of a bank account, however that will increase the level of risk slightly. Your money is locked away for a period of time which means you can't access it if you need it or if a better investment opportunity comes along (for example if term deposit rates go up).
- Shares are a classic example of a high risk, high return investment. If you invest in shares, the value of your investment will change every minute of every day; sometimes quite significantly. In addition, it's possible to lose your investment entirely if the company you're invested in collapses. On the positive side, the share market in general has shown impressive performance over the long term and there are many examples of individual shares that have provided truly spectacular returns to investors.
Fortunately there are ways to reduce risk.
Give it time - Investments with high potential return can be volatile in the short term but tend to be more consistent over longer time periods. For example, if you invest in the share market for a period of 12 months, there is a reasonable chance of a negative return. If you invest for ten years, the chance of a negative return is lower.
Diversification is vital - Diversification involves spreading your investments across a number of asset classes (shares, property, fixed interest, cash), a number of sectors within those asset classes and a number of quality assets within those sectors.
A well-diversified portfolio means that poor performance in one area is less likely to destroy your overall portfolio. Hopefully other asset classes or sectors will perform better and will compensate.