Risk And Return: What People Forget When Investing


 

A big mistake people make when they begin investing is thinking of it as a “get rich quick” scheme. Despite the many financial miracles and underdog stories you hear, that’s far from the reality. Unfortunately, this realization can be disheartening for many first time investors as we live in a time where everything works at lightning speed (internet, fast food, delivery services etc). Therefore, people are getting used to instant gratification; we want everything now with as little commitment and as much gain as possible. 

Maybe one of the biggest things people overlook while investing, is the idea of risk and how it will affect one’s profits. Whether you’re investing in stocks, equities, real estate or any other kind of financial asset, it’s important to know the role risk plays in the investment process, as well as how to set reasonable expectations for your returns. This article covers the relationship between risk and return on investment.

Firstly, we need to know what a return on investment (ROI) actually is. In short, ROI is a metric which determines how profitable an investment is. It’s calculated by dividing the net profit of an investment by its initial value. In short: 

ROI= [Present value – Initial value] / Initial value

 

Risk/Return Tradeoff

In theory, the return on your investment is directly related to the level of risk you’re taking, this is called the risk/return tradeoff. Though there’s more at stake, potential returns will be greater with high-risk investments. Similarly, the more you own of a business or asset, the more likely you are to generate a profit when it’s performing well. However, you will also incur more loss when it’s underperforming. The fact is, there’s no such thing as a risk-free investment. Here are two risks to consider:

 

  • Loss of capital: whether it be the underperformance of your asset compared to its historic performance or a host of other factors, you risk losing some of your investment or all of it. 
  • Decrease in value: returns on your investment are always affected by factors which are totally out of your control. For example, the global economy may go through a period of high inflation, effectively reducing the purchasing power of your money.  

Risk is subjective though, right? What one person considers risky might seem reasonable to someone else. While there is some truth to that, there is an actual measure used to decide the risk factor of an investment.

 

Volatility

Volatility refers to how much the value of an asset fluctuates. Basically, It’s a measurement telling you how risky a certain investment is. If the price swings frequently in a short amount of time, then the asset is considered highly volatile and therefore, a risky investment. This can be quite daunting for first-time investors, seeing downward trends can put people off investing altogether. That being said, they might miss out on the potential to gain profit once the asset recovers. 

 

What Makes A “Good” ROI?

When it comes to investments such as stocks, an ROI of 10% is widely considered a good return and was the expectation for several decades. Although, recent capital market assumptions expect an overall decline in annual returns over the coming years. 

In fact, Robert Ibbotson, whose research formerly supported the annual 10% expectation, now thinks it will drop to 8% [1]. Others are predicting a drop to roughly 6.6% for small and large-cap stocks for the next ten years [2]. 

There’s a lot of factors driving these new assumptions. Whilst the start of 2020 saw a record peak for the stock market, the spread of COVID-19 brought a wave of volatility and uncertainty. Within the first few months, there were sharp declines across virtually all sectors. Even as vaccines continue to roll out and we see gradual recovery, the pandemic has created a significant rift between the best and worst performing sectors, the largest in recent history [3]. 

Lockdowns and other policies introduced to tackle the virus had considerable effects on most industries. Consequently, it will take time for businesses to adjust to these changes. When it comes to investing in stocks, current assumptions point towards the average return being lower than previous expectations. Does that mean you should stop investing altogether? 

Not at all!

Financial markets have their ups and downs yet, they seem to recover in the long run. When it comes to investing, thinking short-term and having unrealistic expectations can lead to missing out on potential growth over the long term.  

 

Things To Consider When It Comes To Risk:

As we’ve emphasised already, there’s no such thing as a risk-free investment. Although, there are ways you can manage that risk. Here are a few important factors to take into account.  

 

Diversification 

Don’t put all your eggs in one basket! 

Putting all your weight behind one investment is perhaps the biggest risk you can take, because if that investment fails you’ll be left in a very vulnerable position. Spreading your investment across multiple assets might decrease potential profit in the short term, but it also reduces the risk factor and gives you other avenues for profit. This is what experts mean when they tell you to diversify your portfolio.  

 

Investing And Speculating, Know The Difference

The line between investing and speculating can seem blurry. In a nutshell, when we talk about investing and speculating we’re talking about two different approaches to investment. When you invest, you’re taking a calculated risk and making a decision without expecting an immediate payoff. Investing is not a gamble, despite what some believe. It requires patience and deliberation, you’re putting your money away with the assumption you won’t see it for a while.

Speculating on the other hand, is a radically different approach. It’s a short-term and fast paced practice that depends on high volatility, when you speculate your investment is based on chance. Speculation presents a grey area in halal and ethical investing as, when investments are made without moderation it’s very close to gambling. Practices such as day trading and crypto trading can become a game of chance as they rely on the estimated potential of assets, instead of the capital generated by them. 

At various points in history, periods of speculation drove the value of shares therefore, speculation plays a significant role in financial markets. Today, social media and the development of blockchain technology have kicked this phenomenon into fifth gear. In 2020, the number of companies valued at over 100 times their revenue, reached an all-time high [4]. Needless to say, it’s a topic that deserves its own article altogether.

Knowing the difference between these two, will help you understand how to go about investing and what kind of investments suit you.

 

Know What Strategy Works For You

What kind of investor are you? 

Are you a risk-taker or someone who plays it safe? Have you thought about short/long-term goals? These are things you need to consider before looking at the options out there. Have a vision for what you want to achieve, think about how much risk you can tolerate and ask yourself whether you are a conservative  investor (i.e. one who favours low risk/ long term investments) or an aggressive one (one who favours short term, higher risk investments). 

Deciding which approach to take is based on your personal risk tolerance; how much of a loss you’re willing to incur if worse comes to worst. There are a number of factors to consider:

Age: some advisers would recommend that older investors be more conservative, whilst younger investors are more likely to take risks. In theory, the younger investors have more time to recover from potential losses, as they are early in their careers and likely to have less financial commitments. However, older investors who are closer to retirement have a lot more at stake. Of course, this is a generalization and will differ depending on individual circumstances.

Time horizon: this is basically the timeframe for your investment, how long you are expecting to hold your assets before you need to withdraw your money. This goes back to having an overall vision, what are your financial goals and when do you want to reach them.Then ask yourself, what kind of investments align with your time horizon? 

Your budget: before investing, it’s crucial that you resolve any outstanding debts and make sure your budget is manageable. Being able to make small but regular deposits into an investment account will serve you better in the long run. Whereas, sporadically dropping huge amounts of wealth may not. Budgeting will help determine your risk tolerance and choose the best investments for you.

All in all, risk is an inevitability when it comes to investing and it directly correlates with profit. A low-risk investment won’t yield the same results as higher risk ones could, at the same time higher risk investments carry a greater potential for loss. Risk is a crucial consideration for any investor, whether you’re actively involved in trading or you’re delegating the task to your portfolio manager. 

For our clients and prospective clients, find out more about Wahed’s  assumptions and investment model here

 

*As with any investment, a Wahed Invest Ltd investment puts your money at risk, as the value of your investment can go down as well as up. If you are unsure about whether investing is right for you, please seek expert financial advice

 

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All investing involves risk, including the possible loss of money you invest, and past performance does not guarantee future performance. Historical returns, expected returns, and probability projections are provided for informational and illustrative purposes, and may not reflect actual future performance. Wahed assumes no responsibility for liability for your trading and investment results. It should not be assumed that the methods, techniques, or indicators presented in these products will be profitable, or that they will not result in losses. Past results of any trading system published by Wahed, through the website at www.wahedinvest.com (”Website”) or otherwise, are not indicative of future returns by that system, and are not indicative of future returns which will be realized by you.

 

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All investing involves risk, including the possible loss of money you invest, and past performance does not guarantee future performance. Historical returns, expected returns, and probability projections are provided for informational and illustrative purposes, and may not reflect actual future performance. Wahed assumes no responsibility for liability for your trading and investment results. It should not be assumed that the methods, techniques, or indicators presented in these products will be profitable, or that they will not result in losses. Past results of any trading system published by Wahed, through the Website or otherwise, are not indicative of future returns by that system, and are not indicative of future returns which will be realized by you.

 

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All investing involves risk, including the possible loss of money you invest, and past performance does not guarantee future performance. Historical returns, expected returns, and probability projections are provided for informational and illustrative purposes, and may not reflect actual future performance. Wahed assumes no responsibility for liability for your trading and investment results. It should not be assumed that the methods, techniques, or indicators presented in these products will be profitable, or that they will not result in losses. Past results of any trading system published by Wahed, through the Website or otherwise, are not indicative of future returns by that system, and are not indicative of future returns which will be realized by you.

 

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Wahed Invest (Pty) Ltd, registration number 2020/726348/07 and FSP number 51684, is an authorised financial services provider under the Financial Advisory and Intermediary Services Act (No. 37 of 2002). This information is not advice, as defined in the Financial Advisory and Intermediary Services Act (No. 37 of 2002). Investment products are market linked. Market fluctuations may have an effect on the value, price or income of investments. Investment capital is not guaranteed, unless specifically stated. Past performance is not a guide to future investment performance.

 

Citations:

[1] https://www.seattletimes.com/business/why-you-should-plan-on-lower-market-returns-for-life/

[2] https://www.schwab.com/resource-center/insights/content/why-market-returns-may-be-lower-in-the-future

[3]https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/the-impact-of-covid-19-on-capital-markets-one-year-in
[4]https://www.theguardian.com/business/2021/jan/09/is-hysterical-market-speculation-pushing-us-towards-another-crash#

 

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