Investors don’t have to limit themselves to certain asset classes to preserve their capital. Here’s a quick look at why creating a low risk portfolio is the better option.
A low risk portfolio is a collection of diversified investments that present a slimmer chance of capital loss from various market risks. It focuses on providing income while reducing exposure to market volatility and other risks—but it is not as simple as selecting specific asset classes.
While diversification can be effective in minimising risk, it remains up to the investor to create and employ a sufficient risk mitigation strategy to ensure the safety of their capital. An investor may either employ strategies to manage risks in their portfolio or select assets that can weather downturns in the investment market.
What risks affect investments?
Risk is always present no matter what type of investment is acquired: there is no single type of risk that severely affects a well-chosen portfolio. Investment assets are always exposed to market risks and, when certain conditions align, could create huge profit or loss for the investor.
Here are three common risks all investments face:
- Inflation
- Interest rate
- Market volatility
Inflation risk
Inflation affects all aspects of the economy and it also weakens the value of a dollar. This means investments that cannot catch up with rising inflation rates stand to lose capital because the principal investment’s value decreases over time.
For example, according to the Reserve Bank of Australia, a commodity valued at a dollar in 2007 would cost $1.26 in 2017. This translates to a 26.4 per cent increase over 10 years or an inflation rate of 2.1 per cent annually.
This means a $100 investment that ‘earned’ $50 over the same period actually only earned $23.60 because of inflation.
Interest rate risk
Inflation and interest rates are inversely proportional to each other and their movements can dictate the outcome of investments.
For instance, if interest rates increase or decrease at any point during the investment period, issuers may be forced to recall their offered securities—a risk that typically accompanies bonds.
When interest rates fall, issuers are at a disadvantage when they pay investors for high-interest bonds. In cases when a bond is callable, issuers end the bond’s term instead and issues new bonds with lower interest rates.
When conditions are reversed and interest rates increase, bondholders with smaller coupon may find it difficult to liquidate their investment if issuers offer newer bonds with higher interest rates.
Market volatility
Regardless of the stability of an investment’s underlying business, market volatility can decrease the value of investment returns, which can come in the form of coupons, dividends or distribution payouts.
However, investors should be aware that market movements can also increase the price or value of investments.
What makes up a low risk portfolio?
The following assets are typically included in a low risk portfolio allocation:
- Cash-based investments
- Bonds
- ETFs and index funds
- Real estate investment trusts
Cash-based investments
Cash-based investments may come in the form of high-interest savings accounts, term deposits or any other account in which the cash is not traded for another asset class.
These types of accounts allow an investor to retain liquidity of their investment by keeping it in cash form. However, cash is usually the biggest casualty of inflation risk. Unless an investment is hedged for inflation, cash-heavy portfolios rarely have the capacity to keep up and retain its value.
Term deposits could enable cash to keep up with inflation because it offers account holders higher interest rates in exchange for a lock in term.
Bonds
Bonds present a lower level of risk compared to shares because investors are assured of regular interest payments and a return of their principal investment upon maturity.
Notes, or bonds that mature in less than 10 years, are usually designed with protection against inflation through benchmarked coupon payments.
While bonds are generally ‘safe’ investments, there are still some high-risk versions of the security. Its best for investors to practice due diligence when selecting debt securities.
ETFs and index funds
Low cost exchange-traded funds (ETFs) and index funds track benchmarks and indices, which give investors instant diversification. They may also be traded in the Australian Securities Exchange (ASX), which provide the liquidity risk-averse investors want.
ETFs and index funds typically cover a large investment spread, which not only diversifies the underlying assets, but also opens opportunities to invest in international markets.
Real estate investment trusts
Real estate investment trusts (REITs) may also be traded in the ASX. Unlike typical property investments which requires investors to purchase physical structures, REITs are a type of mutual fund that allows a person to invest and earn from the fund manager’s property.
It also offers investors better liquidity and the opportunity to avoid debt, than if they purchase an investment property through a property loan.
Effective low-risk portfolio strategy
Managing risk by creating a well-diversified portfolio is one of the most effective ways to protect against risks. However, investors should understand that diversification is simply a means to preserve capital by offsetting potential losses from higher risk investments.
That is, a low risk portfolio is not necessarily a pool of ‘safe’ investments, but rather a basket of assets in which one investment’s strength makes up for the vulnerability of another.
Investors should discuss their objectives and risk appetite with a licensed financial advisor, so their personal circumstance may be taken into consideration when creating a low risk portfolio.
This information has been sourced from the Australian Taxation Office, Reserve Bank of Australia and Nest Egg.
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We Translate Complicated Financial Jargon Into Easy-To-Understand Information For Australians
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