Update: Prior title ‘Get Highest Return for Lowest Risk’ has been amended for better reflection of the point of article.
I see that look of skepticism in your eyes. Allow me to explain.
Too good to be true?
Any investment’s risk-return ratio has traditionally been generalised as either: ‘High risk, high returns’ OR ‘Low risk, low returns’.
Over time, with increasingly sophisticated investors and hence, increasingly diverse and complex financial products, financiers began to plot these products across a risk-return trade-off map, of the traditional returns products would generate in return for risk.
How does one understand this? By going back to basics.
Exactly how do you determine returns? That’s easy.
For most financial instruments, the Return On Investment (ROI) or how much you profit from investing can be measured either by capital gains or dividend/coupon yields.
Capital gains are the price appreciation of your investments e.g. increasing share prices, currencies strengthening against others, in-demand tradable bonds, etc. in the markets.
Dividend/Coupon yields are the distribution of profits from your financial instruments e.g. high coupon rates from bonds, increasing dividends from shares, bonus premiums from endowment/investment-linked policies etc.
That’s a lot of dollar bills, Donald!
Now that we have a clearer understanding of returns, what about risk?
In finance, risk can defined as the uncertainty associated with any investment or the beta (volatility) of an portfolio.
That’s where it gets a lot trickier.
As one sees from the infographic below, there can be many various types of risk – and of course, so much more risk can be unaccounted and unexpected. (although pretty unimaginable events would typically be covered in legal contracts under ‘Acts of God’)
Check any investment prospectus’ ‘Risk Factors’ and you’d see there’s a huge amount of contextual risk depending on the firm and its industry/market conditions.
Now that we understand exactly what returns and risk are, how does that lead to our application of the risk-return spectrum that ranks the world of finance investments?
I would like to suggest using a different lens to look at risk.
Firstly, I believe that risk is not the same to everyone.
According to the materiality concept in accounting, a transaction or item is material (significant) if it affects decision making. The value of a transaction or item is hence compared to the size and nature of the business in terms of income, profit, assets, etc.
Source: All About Principles of Accounts (POA) (yes, it’s my subject textbook)
To understand this concept better, take for example, that $1,000 might not mean much to a millionaire, but would be a huge sum to a poor beggar, no?
In addition, an experienced and knowledgeable financial advisor would know how to handle and manage risks better than a new and young investor to the markets.
Hence, risk should be measured subjectively e.g. in accordance to one’s life-stage, financial profile, investment savviness/personalities, ability to absorb risk, etc.
But they told me to hold the money in cash!
That would also mean that the risk-return ratio would vary across different individuals.
Secondly, if you are unable to handle much risk/volatility in your finances, should you still aim for that new-fangled, complex financial derivative that no one really understands?
Of course not.
So when it comes to getting the highest returns for the lowest risk from investments, one should either gain as much funds or gather as much investment knowledge/experience As Soon As Possible (ASAP) to make wise, informed investment decisions.
This will allow one to slowly build up a war-chest of capital to invest carefully with the sage advice one accumulates from experts or even better, from pure, personal experience.
Try, fail, try again! (Only smarter this time, for heaven’s sake).
After all, there is a Chinese saying that failure is the mother of success! With more funds and experience, one would be prepared to take up greater amounts of risk (which would ironically, be lowered risks in the light of one’s increased wealth and knowledge) in exchange for higher returns.
Otherwise, it might be better buying 4D/Toto.
No offence to 4D/Toto buyers! After all, as some have also told me: It has the Highest potential Return for the Lowest Risk! 😀
(I have my doubts about that due to the low probabilities of striking 4D/Toto, but that’s for another day I guess)
In conclusion, to maximise returns while minimizing risk, do these two things:
Keep accumulating and growing that war-chest of funds to invest
Keep learning and applying your investment knowledge in the markets.
With that, may your portfolio gain the Highest returns for the Lowest risk this 2018! (Huat ah!)
Live long and prosper,