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June 16, 2021

Understand the Risks

 Risk vs. Return


Is there a risk-free life? Every decision you make, whether buying a car, riding a rollercoaster, or starting a family, all have the risk of it happening unexpectedly. But to isolate yourself in a solitary room in order to avoid all the risks in daily life, you will also not get any benefit.



Yes,  we will learn about risk.


 


Financially, we define risk as to the likelihood for the actual return of another investment from your initial expectations. In other words, chances are you will lose money or make a little more profit than you expected.


 


The main rule of investing is that the higher the expected return, the higher the risk. This is known as a risk-return trade-off. A high rate of return is worth the high risk. No high returns with no risk at all. However, there are strategies that can be used to manage and reduce risk.


 


Today's Word: Fluctuations


The value of the investment price goes up and down. How fast it fluctuates is a measure of the risk of the asset. The higher the volatility, the higher the risk.


 


Diversification


We often hear the phrase "don't put all the eggs in one basket." If we change it to “don’t spend all your money on one type of investment”, we’re talking about diversification.


Every asset you buy comes along with market risk - its value can go down. There is always the unexpected. Thus, by putting money on different assets, it can reduce the risk of them all falling at the same value.


On the first day, we learned about unit trusts. Investing in unit trust funds is the best and cheapest way to get diversification as they give you exposure to many companies, different sectors, and even other asset classes.


 


Opportunity Cost


You buy a luxury mobile phone, and with the same amount of money, you can buy another brand with similar features but at a lower price. This is the risk when you make an investment decision. Based on that experience, you realize that you can use that money elsewhere better. This is a risk that we are not aware of when saving money as cash only. Yes, saving cash can avoid some risks, but we incur huge opportunity costs when we may be able to maximize the potential of that money elsewhere.


 


Risk Tolerance


Your risk tolerance is how comfortable you are to take risks. This shows how much risk you are willing to take in achieving your investment goals. Understanding your risk tolerance is important. If you take too much risk and are unable to take large losses from your investment, you may face stress and make panic sales at the wrong time.


 


Investment Period


Investment period refers to the period of time you set to be in the investment. The term can be short-term, just a few days or months, to long-term, can span years to decades. Your EPF contribution is an example of a long-term investment.


When investors have a longer timeframe, they are able to take more risks, as the market has many years to recover in the event of a crisis. That is why there is an expression that in the long run, the market tends to go up.


On the other hand, over a shorter period of time, you may have to sell your investment during a market downturn at a low value. Therefore, short-term investments should have less risk to reduce the likelihood of such investments depreciating in the short term. For example, a 2 -month investment should be in the form of a cash investment only.


The timing of this investment can be more important than risk tolerance when making which investment choices you should make. Especially when the term of the investment is very short or very long.