Balancing risk and return for long-term success

Investment returns typically come from two sources: income (such as rent or dividends) and capital growth. While many investors focus on growth potential, others prioritise income stability. Understanding the relationship between risk and return is crucial for building a balanced portfolio.

Understanding Risk and Return

In investing, risk is best understood as uncertainty. Low-risk investments like term deposits offer predictable but low returns. In contrast, higher-risk investments such as shares have uncertain returns but historically have produced higher long-term gains.

However, avoiding investment risk entirely can expose investors to the risk of not achieving their financial goals. Conservative investments may not provide sufficient growth to sustain retirement savings over the long term.

The Impact of Risk on Long-Term Returns

Even small differences in average annual returns can significantly impact long-term wealth accumulation. For example, over a 35-year period, a 2% difference in annual returns can result in a substantial disparity in final portfolio value.

This difference becomes even more pronounced when considering retirement income. A larger portfolio built through higher-risk, higher-return investments can potentially support a higher annual pension for the same duration as a smaller, more conservatively invested portfolio.

Striking the Right Balance

Financial advisers aim to achieve an appropriate balance of “growth” and “income” assets when constructing client portfolios. This balance should reflect the investor’s:

1. Risk tolerance
2. Investment timeframe
3. Financial goals
4. Need for income vs. growth

It’s important to note that while higher-risk investments can lead to greater returns, they also come with increased volatility. Investors must be prepared to weather short-term fluctuations for the potential of long-term gains.

Conclusion

While it’s tempting to avoid risk altogether, doing so may jeopardise long-term financial goals. By understanding the risk-return trade-off and working with a financial adviser, investors can create a portfolio that balances the need for growth with their comfort level for risk.

Remember, the right investment strategy is highly individual and should be tailored to your specific circumstances and goals.