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Investing in anything comes with an inherent risk. When we look at an investment instrument, we often see the returns it has generated over the past decade or so. No matter which investment instrument you choose, there’s always a risk of losing money.
There are two main ways of looking at investments. You can either look at it from a returns perspective, or from a risk-adjusted perspective. In the latter, you take into account how much risk you are willing to take to generate a higher yield. In this article, we will look at ways to generate a meaningful yet risk-adjusted yield from your investments.
How is risk defined in investing?
Investment risk is typically defined as a variance from a predicted outcome. It can be stated in terms of an absolute value or in comparison to another object, such as a market standard. It’s possible for that deviation to be favorable or unfavorable. Investors need to be more accepting of short-term instability if they want to generate larger profits over the long run.
The level of volatility is determined by the investor’s risk appetite. Risk tolerance is nothing more than the inclination to accept volatility in particular financial situations. It takes into account your emotional and physiological comfort level with unpredictability as well as the likelihood of suffering significant short-term setbacks.
Why is it important to calculate risk?
If you do not understand the risks of an investment, you cannot invest in it safely.
Let’s look at cryptocurrency for example. For several years, Bitcoin gave amazing returns. At the same time, anyone who invests in Bitcoin should also understand that it’s a very volatile investment instrument. You could lose hundreds of thousands of dollars in a matter of hours, if not minutes.
But when you understand the risk of investing in Bitcoin, you can diversify other investments accordingly. Debt instruments, for instance, are more stable than equity instruments. Both are more stable than alternative investment instruments like crypto. When you diversify the investments correctly, losses in one can be covered by gains in another.
It’s crucial to understand risks before investing in anything. There’s no other way of generating a meaningful yet risk-adjusted yield. In any other approach, you are either going big or going home. For long-term, sustainable returns, it’s essential that you understand the risks involved with a specific investment instrument.
How to generate a meaningful, risk-adjusted yield?
We generally park money in a personal or business savings account. As we all know, these accounts give very poor returns. However, if you look at it from a risk-adjusted perspective, a general savings account makes sense.
While you do not get much in terms of returns, your money is parked safely. At the same time, you do not need to worry about market ups and downs or asset diversification.
But when you factor in inflation, you may actually be losing money by parking it in the bank account. That’s why we look for alternative investment instruments.
Understand your investment
When you invest your money in a mutual fund, ETF, or stock, you already have a fair idea of how risky it is. Investing in a small cap fund is inherently riskier than investing in a large cap fund. The same goes for the companies you invest in. An established company may not give an amazing short-term return, but almost always gives a good return on a long time horizon.
Understanding where your money goes is important. Before you invest in a fund, study its risk-return ratio.
Portfolio diversification is the practice of putting your money in a variety of instruments and asset classes to reduce the portfolio’s risk level. Just consider the results of placing all of your funds in a single stock. As long as its performance is favorable, everything will be great. But if it decreases, all of your money will too.
The cornerstone of earning a significant yet risk-adjusted return is portfolio diversity. Diversification is influenced by a number of variables, including age, risk tolerance, and income. Young people with no dependents find it easier to take more risks compared to older people. It’s crucial to work with an experienced financial expert to correctly diversify your portfolio.
Calculate risk levels
There are different models to calculate the risk level of an investment. Sharpe ratio and Treynor ratio are the two most common ways of doing it. These calculations require a fair amount of expertise and are best left to professionals who have a deep understanding of these concepts.
We hope this guide will help you come up with ways to generate a meaningful and risk-adjusted return from your investments. However, remember that no investment is 100% risk-free. When faced with any doubts, reach out to a consultant to not make expensive mistakes.