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Before understanding investment performance and why some ‘balanced’ funds perform better than others, it’s important to understand investment risk.
Investment risk is defined as the chance you will lose money on an investment however it also provides an opportunity to make money.
As all investments come with varying degrees of risk, it’s important to build a portfolio that suits your risk tolerance.
There are several factors that measure risk tolerance:
Your desire to take riskSome investors enjoy high-risk investments because of the opportunity for higher investment returns. Most investors however have an aversion to the stress that a large fall in an investment’s value can produce. As a test, ask yourself how you would feel if you woke up and the value of your investment had fallen by 10 %? 20 %?
Your financial capacity to take riskA couple with a new baby and a mortgage will have a considerably different capacity to take risks than a single person earning a high salary and a successful career.
Your need to take riskThis is tied to your investment time frame. If you are 30 years old and planning 35 years ahead for retirement, you will probably be happy to accept greater risk to achieve your goals, as short-term losses are smoothed out over time. On the other hand, if you are nearing retirement, you’ll probably not want to risk losing your money as there isn’t the luxury of time to recover from losses.
With greater risk, there is the opportunity for greater returns. Different types of investments, or asset classes, have greater risk and the possibility of higher returns. As shown in the graph below a ‘cash’ investment is low risk but with low return while shares are likely to produce a higher return but with a higher risk of losing money.
Each asset class has individual characteristics and carries a different level of risk and return to suit a range of investor types.
Asset classes fall into two main groups: defensive and growth.
Cash and fixed interest (bonds) are usually considered defensive assets while property and shares are usually considered growth assets.
Different types of investments, such as shares and bonds, perform well at different times. With a mix of investments, if one part of your portfolio suffers losses, other investments may remain steady or even appreciate. Over time this will smooth out the returns of your portfolio and protect against the risk of catastrophic losses.
There are different levels of diversification to properly manage risk:
When you read the terms ‘cash’, ‘conservative’, ‘balanced’ and ‘growth’ in relation to investment portfolios, this is what it means1:
In reality, different super funds may have different names for their portfolios, such as ‘high growth’ instead of ‘growth’ and asset allocations may not be the same as above.
Fund X has a balanced fund with 50% invested in fixed interest and cash assets and 50% in shares and property.
Fund Y has a balanced fund with a 21% allocation to cash and fixed interest assets and 79% in shares and property.
Over 10 years fund X, has an annual return of 8.69% while Fund Y has a return of 9.32%. This is due to Fund Y being invested in riskier assets and while it has outperformed Fund X in the long term, short-term investment lows may have been highly uncomfortable and caused some investors a high degree of stress.
It’s important to read your fund’s product disclosure statement to find out how money will be allocated across each asset class for each fund’s investment option. It’s also important to make sure it aligns with your appetite for risk.
Understanding what type of investor you are, and therefore what types of investments are most suitable to you, is all about your personal circumstances and your attitude towards investment risk.
The IOOF Risk Profiling tool has been developed to help you better understand what sort of investor you are.
Keep building your knowledge of investing and visit the Investing web page
A financial adviser can help you understand your risk profile and build a portfolio of investments that matches your risk profile and your investment objectives.
1 - ASIC’s Moneysmart website, goals and risk tolerance