Investing: sailing in unknown waters

Investing is like a voyage in unknown waters. To succeed, you need to consider two important factors: risk and reward. This article delves into the fascinating world of investing, explaining the concept of risk and the nature of returns, and exploring why higher risk often leads to higher returns.

Like any voyage into new waters, investing is fraught with uncertainty. An investor's goal is to strike a balance between risk and reward to maximise potential gains while minimising potential losses. This article will give you the knowledge and tools you need to build an investment portfolio that is both profitable and resilient.

In this article:

• Understanding risk and reward: What is risk and return in the investment context? How do they relate to each other?
• Factors affecting risk and return: What are the factors that influence the risk and return of an investment and their balance?
• Why higher risk leads to higher returns: Why do investors demand compensation for higher risk?
• Diversification and risk management: How can diversification of the investment portfolio help to hedge risk?

Let's start our journey into the world of investment!

1. Definition of risk and reward 

When making investment decisions, it is important to understand clearly what the risks and rewards of investing are. Risk is not just a scary word. In fact, navigating risk consciously can help you achieve your investment goals.

1.1 Risk levels of investments:

Investment risk is not black and white. It is a spectrum with different degrees of risk. For example, equities are generally higher risk than bonds, as equity values can fluctuate higher or lower, while bonds are generally relatively stable. Real estate, on the other hand, is an asset class that can be further subdivided into commercial real estate and residential real estate. As people will always need somewhere to live, but businesses can go bankrupt in more difficult times, commercial property carries more risk between these two sub-classes. 

Take for example the recent corona crisis- a number of companies changed their working arrangements to allow employees to work from home, either full-time or at least part-time, significantly changing their need for office space. Although the crisis is over, many companies continue to allow part-time working from home. Although the crisis had a strong impact on demand for commercial property, the impact on residential property was not the same. 

1.2 Income diversity:

To better understand the risk of an investment, it is also worth knowing the types of return. Returns are not limited to monetary gains. Investment returns fall into two main categories: capital gains and dividends or interest. Capital appreciation refers to the increase in the value of an asset over time. For example, if you buy a share for €10 and later sell it for €15, you will earn €5 capital gains. Dividends, on the other hand, are the profits paid out to the company's shareholders. For some companies payment of dividends a regular activity, providing investors with an income stream.

2. Balancing risk and reward

Finding the right balance between risk and return is the key to success in investing. This balance depends on your investment horizon and risk tolerance. The investment horizon is the length of time you intend to keep your money invested. There are different strategies and explanations. 

For example, there are experts who believe that low-risk investments such as deposits or fixed-term accounts are suitable for short-term savings. For long-term purposes, for example saving for retirement, it is more appropriate to take a higher risk in order to potentially earn a higher return. If the aim is to accumulate for retirement, the risk tolerance will generally gradually decrease over time, as the risk of something happening to the assets accumulated for retirement is generally too high. 

Risk tolerance is a measure of how comfortable you are with potential losses. Some investors are very risk averse and prefer to invest conservatively. Other investors are willing to take more risk in the hope of higher returns. Understanding your own risk tolerance will help you choose the right investment strategy. 

3. What influences the balance between risk and return?

In the world of investing, there are several factors that influence the balance and the relationship between risk and return. These factors, outlined below, will help you assess the potential profitability and risk of a particular investment.

• Type of investment: Different asset classes have different levels of risk. In addition to the relatively new asset class, cryptocurrencies, equities are generally the most volatile, and their values can fluctuate widely. Bonds are generally less risky, as investors are guaranteed a fixed interest rate. Real estate is another asset class with its own risk objectives. For example, renting commercial property can be riskier than renting residential property, as it is more dependent on the current economic situation.
• Quality: When investing in a company, its governance and overall quality have a significant impact on investment risk. It is likely to be less risky to invest in a well-established and financially stable company than in a start-up. Shares in high quality companies may offer more stable growth and income streams. 
• Duration of investment: The investment horizon plays an important role in balancing risk and return. For short-term investments, it is prudent to favour lower-risk options. However, long-term investments, such as saving for retirement, may involve higher risk assets, as a long-term perspective allows stock market volatility to be smoothed out.
• Market conditions: Overall market conditions affect investment risk. Investors have a higher risk tolerance in bull markets because all asset classes are generally rising. However, in a downturn, risk is higher and investors should be more cautious.
• Investor behaviour: It is important to maintain common sense when making investment decisions. Emotional reactions to market fluctuations can lead to over-risk tolerance and losses. Sticking to an investment plan and thinking long-term can help reduce the impact of emotional decisions.

4. Why does more risk bring more return?

In the world of investing, the higher the risk, the potentially higher the return. But why should investors take any risk at all? Here are a few reasons:

• Risk premium: risk can be thought of as a premium to be paid for higher potential returns. Investors demand higher returns in return for higher risk. For example, investing in a lesser-known company with high growth potential. The potential rewards are higher, but so is the risk. Unless the prospect of a return was particularly high, no one would have an incentive to take a big risk. 
• The entrepreneurial spirit: Innovation and growth often depend on entrepreneurs taking risks. By investing in innovative ideas, the risks are shared with the company, but the hope is that the innovative idea will prove particularly profitable. In addition, professional investors often have their own interests and hobbies, and if there is a personal interest in a particular area, there may be a desire to support it by tolerating greater risk. 

5. Diversification and risk management

Diversification is the golden rule of risk management in the investment world. It's a strategy that involves diversifying investments across asset classes, sectors and geographies. This way, the success of your investments is not dependent on the state of any particular asset, company or economy.

Investment Portfolio Diversification has the following advantages:

• Reducing investment risk: Different asset classes have different characteristics. Some assets may depreciate while others may appreciate. Some companies may go bankrupt while others grow like crazy. By diversifying your investment portfolio, you can smooth out market fluctuations and reduce your overall risk.
• More stable returns: A diversified investment portfolio offers more stable and predictable returns. Even if one asset class makes a loss, other assets can compensate. This helps you achieve your financial goals over a longer time horizon. 
• Greater potential: While diversification reduces risk, it does not necessarily reduce potential returns. In fact, it is possible to achieve equivalent or even higher returns by diversifying your investments wisely.

The range of diversification strategies is wide:

• Diversification of asset classes: Invest in shares, bonds, real estate and alternative investments.
• Sector diversification: Invest in different sectors such as technology, healthcare, financial services, etc.
• Geographical diversification: Invest in companies from different countries and regions.

It is important to take into account your risk tolerance, investment horizon and financial resources in order to successfully diversify. It is also important to rebalance your portfolio regularly to ensure that your investments are diversified over time.

Diversification is not risk-free, but it is probably the best way to mitigate risk and ensure the long-term success of investments.

Closing words

Investing is an exciting journey that can bring significant rewards. Risk and return are two important companions on this journey. However, risk is not necessarily the enemy, but rather the reward for higher potential returns. However, it requires an understanding of the relationship between risk and return and your own tolerance for risk. This will enable you to make more informed investment decisions and create a balanced portfolio that will lead you to your financial goals.

Investing is not a gamble, but a long-term strategy. Just as a captain does not set out on a voyage until he has studied the weather and course, you should not start investing until you understand the dynamics of risk and return. This article was just for you the start of an investment journey. Keep exploring, keep learning and make informed decisions to secure your financial future. I wish you success in the world of investing!