Risk-reward equation forms the basis of all financial planning. It is based on the premise, that your potential gain or reward is directly proportional to the amount of risk or potential loss you are willing to take. The equation means that you tend to make less money from “safe” investments that are low-risk and more money if you invest in risky assets.
Fixed and variable income assets
Income from financial assets or real assets can be characterised into two types – fixed income and variable income.
When you get a fixed return by owning an asset, it is called a fixed income. For example, the return on a fixed deposit is known in advance and is preset. Similarly, provident fund returns and bond interest rates are known. Even rent from a property can be considered to be fixed income as you are already aware of its exact amount.
Fixed income investments are less volatile and have little or zero credit risk. However, they generate low rates of return than the variable income instruments. Fixed income investments are preferred where capital protection [safeguarding the money rather than growing the money] is a major investment criteria and also when the investment horizon is not very long. However the returns from such “safe” investments are not very high and just about beat inflation.
On the other hand, you have the potential to make higher gains from more risky investments such as stocks and property. However there is a strong possibility that you might end up losing money in such “risky” investments. Income which is neither fixed in nature nor has a guarantee of the return is called variable income. The most popular example of variable income is equity – or shares, as they are popularly known. Land and property prices fluctuate from time to time, and hence, they are also variable income assets. Commodities, such as gold and oil, are also variable income assets.
They have the potential to deliver a higher rate of return than then fixed income investments and also beat inflation. Due to their volatile nature, they are a preferred investment vehicle for long-term capital appreciation [growing the money at the risk of losing it].
Decide where to invest
If you choose to invest into all safe investments, you will have peace of mind as far as capital safety is concerned. However, with rising cost and standard of living, such safe investments may not meet the desired investment objectives in the long run.
On the other hand, if you invest all your money in risky assets, you could make very high returns, but you could also lose substantially.
Thus, it is important to identify your individual investment objectives for the long and short-term to decide on an asset allocation mix [how much to invest in safe assets and how much to invest in risky assets].
Individual considerations in deciding investments
The individual asset allocation preferences are dependant on personal preferences, return expectations, age, income, financial commitments, lifestyle, individual aspirations and long-term vision.
However, it is interesting to note that the most important factor for an individual to have different risk preferences depends on how well he/she is financially.
For example, an elderly retired couple would normally choose to have a large proportion of safe investments in their portfolio to meet their daily needs. They might also invest in high risk investments like equity. The reason could be that they are not really investing for themselves, but for their children or grandchildren. They probably have enough money to meet their daily needs after retirement and want to ensure the money grows well before it goes to their successors.
Also, a young person might not take risk in his investments today because he does not have a secure job. However, when the same guy gets a great job that offers a lot of savings, in a few years time, he will be investing in a lot more riskier assets.
If you have a strong foundation of cash flows and fixed income or safe investments, you can take higher risk. This risk is no longer a bad risk, it is a calculated risk.
By choosing an appropriate mix of fixed income and variable income assets classes wisely, you can create a portfolio that will meet your individual risk profile, short-term to medium-term liquidity [money that you can use anytime and is not locked up] requirements and also meet your long-term investment objectives.
Last but not the least, it is very important to frequently reassess your financial position in order to make the necessary changes in the asset allocation mix of your investment portfolio.