Risk, balance and returns
In which money machines/asset classes should I put my money that will offer me the best return at the lowest risk? I get this question a lot, and there is a simple answer for it:
99% of cases gives higher returns with higher risk.
We don’t want to lose money.
But we do want great returns.
Sadly, with no risk comes no return. It is thus important to start thinking about how risky you are and determine how much risk you are willing to take to get greater returns.
How risky is your behaviour?
Not that long ago, I had a friend who tried to seduce me to invest in his pyramid scheme – the money was fully guaranteed! The returns were amazing, yet, if it went out of business (which is the nature of these types of investments) before I cashed out, I would lose everything.
We want to make loads of money, but not have any risk of losing money – unless the returns are unbelievable. This is also the reason why we ‘invest’ in the lotto: though we have a one in 20 358 520 chance of winning.
Though the above is not investment-related, it’s worth noting how our brains work here: we want to make loads of money with no risk. We want to make money without ever having a chance of losing our money.
Sooner or later we need to realise that this is greed – and that there’s a safe balance between risk and reward.
Risk vs Reward
When it comes to investments, risk and reward are often related.
Higher risk will often mean higher returns.
Yet, you don’t want to stand the chance of losing all your money. You’re able to minimise the risk through a couple of big words such as knowledge, diversification and strategic rebalancing. This article will look into these concepts to help you make sense from the technical jargon out there.
Knowledge and risk
“My stock broker says real estate is a risky investment.”
“Yes, he would say so. Have you ever asked your real estate broker what he thinks about stocks?”
– Cashflow 101
Investments are only risky if you don’t know what you’re investing in.
Many people will claim that something is risky – whether it be bitcoin, investing in gold, stocks, property or smoking nyaope. We must understand what we’re investing in and how they work.
Once we understand what we’re investing in (and how they work), we will be able to:
- Know if we want to invest in the particular asset
- Know if it fits our risk profile
- Understand what storms can be expected and bear them with greater patience.
Asset classes and their risk
To make it slightly easier for you to think about asset allocation, I have created this chart below to show the levels of risk. Cash or equivalents have the least amount of risk, whereas stocks have high risk and are exceptionally volatile.
Note that you can lower the risk of investments by knowledge and diversification, which will be discussed a bit further down in this article. The basic money machines (asset classes) are:
In 2010 a company named Mt. Gox started trading Bitcoin. In their heyday, they were handling 70% of all bitcoin transactions and was the biggest intermediary of the day. Bitcoin was doing exceptionally well during this time and people were investing their life savings in this up and coming technology. In February 2014 all trading was suspended when it surfaced that the company was hacked and more than $450 million (at the time) of Bitcoin was stolen.
It’s the story of so many other companies.
From this story, we learn that we need to spread the risk through diversification and different asset classes and even within the asset class itself so that we safeguard our money.
We need to look after our money.
Asset allocation is how we split our portfolio into the different asset classes by a decided percentage. The reason for this is to put down a rule of what our ideal portfolio should look like from a birds eye view. Asset allocation has less to do with diversification within the asset class and more to do with splitting it across asset classes for risk management.
You need to decide (and sometimes with the help of a financial advisor) how to do your allocations. Here are some examples:
- Mocca Java (25) is risk-averse but wants her capital to grow at the fastest pace possible within legal means.
- She has a 90% Stocks (ETFs and funds) and 10% bonds allocation
- Arabica (55) is retiring in 10 years and wants to play it safe.
- He has 20% stocks (ETFs, RAs and individual stocks) and 40% in investment property and 40% in bonds
- Robusta (12) has full knowledge of bitcoin and has an excellent track record for trading cryptocurrencies profitably for the last 10 years
- She is 100% invested in bitcoin.
Rebalancing of your portfolio
What happens a year from now when your bonds are doing better than it should and your allocation changes? What happens if your goal is 20% bonds but you have 30% bonds?
This is where rebalancing comes in. Every year you can rebalance your portfolio by taking the extra money made (in the example above that will be the 10% overallocated bonds) and move it into the other asset class.
This means that every year you’ll start afresh with your target allocation.
When you get older, you might want more money in safer areas. You might adjust your asset allocation from time to time to fit your risk profile.
Diversification as an investment strategy
Some people say there’s no such thing as a free lunch. But in the world of investing there’s something that comes pretty close, it’s called diversification
Diversification is the process where you split your allocated money to be placed in different places, so that you’re not over exposed to a single company, country or industry.. A well-diversified portfolio will help you weather many storms!
Remember: if you have all your eggs in one basket, you might wake up one morning with nothing! Here are some examples of diversification:
- Mr Espresso wants to invest in stocks, but want to invest in many stocks from various sectors. He decides to buy an ETF that is tracked by an index that invests in different sectors and different companies/industries
- The portfolio is diversified across borders and industries. To make this truly diversified, he will need to buy into other asset classes as well.
- Mrs Latte loves property – she has a few small ones in various locations. She also has some international ETFs and a retirement annuity (which has a good allocation of stocks and bonds).
- She is diversified across borders, asset classes and industries.
Age and asset allocation
We now know that asset allocation has to do with maintaining a split percentage in various asset classes.
When it comes to age, you need to be mindful of the years you have left. This has a direct impact on how much risk you’re able to take to grow your portfolio. Check these examples:
- Young people with many years of life in them can afford to lose a lot of money and still retire well. It therefore makes sense for young people to invest in higher-risk investments with the hope of better returns.
- If someone, 5 years from retirement, loses half their investment, they will die sooner than expected. Older people should allocate the majority of their portfolio in safer assets.
How do I decide my asset allocation?
The Motley Fool has an awesome article on this. Here is a summary:
- Calculate the time left for retirement
- Identify your risk appetite: this could be from “Super conservative” to “Crazy risky like a triple espresso”.
- A simple calculation I have seen out there is 110 – Age = % you need in stocks. Though I don’t think this absolute, it’s a cool thought.
- Decide the asset classes that you have researched (stocks, bonds, property, cash or equivalents and speculative investments), and the percentage you want in each of them.
- Invest and rebalance every year.
No one wants to lose money.
We all want to make lots of money with no risk.
The best way to make the most money safely is through proper diversification and regular (preferably annual) rebalancing of your portfolio.
When you do asset allocation, make sure you consider your age and risk appetite.
My personal blog posts for more reading:
- Ponzi and Pyramid schemes
- Cash or equivalents
- Gold – Investing in gold
- Bonds – Investing in Bonds
- Property – Investing in Property
- Stocks – Investing in Stocks
- ETFs – Investing in ETFs
External sources for extra reading