frog finance

Investing

How and where to invest your money

Risk v Return

The major concept to understand when looking at any potential investment is the trade off between risk and return. The natural supply and demand for capital within the financial markets, and indeed everyday life dictates that investments are priced according to their risk profile. Let us consider an illustration:

Lets assume we go to the bookmakers and place a bet on a horse to win a race at odds of 500-1 where the only other horses in the race have odds of 2-1 and 3-1. Because it is assumed our 500-1 horse has virtually no chance of winning we are offered high odds from the bookmaker. To put this another way betting on the horse is highly risky from our perspective because it is not expected to win. As a result we demand a very high return in order for the bet to be worthwhile. If the same horse had odds of only 10-1 and all other things remained equal we would never even consider the bet.

In exactly the same way as illustrated above all investments available from the financial markets such as shares, bonds or premium bonds etc are valued by gauging the risk and expected return. Lets look at another example more relevant to the financial markets. Shares in companies are basically valued using a combination of a few things; the value of the companies assets (e.g. buildings it owns, value of stock, bank balances etc)and expected future profits based on past and predicted future growth/performance. Shares in a volatile, competitive industry such as the telecommunications sector may be riskier than shares in a food retailer - the logic being everyone needs to eat so demand should be fairly constant, all other things being equal. As a result they usually have to offer a higher return to the investor, maybe by paying higher dividends than companies in other industries.

Determine your appetite for risk

Unless you are clear about how much risk you want to take on with your investments you'll have trouble picking the right investment. This should be a function of your net wealth. For example if you have a small amount to invest, live close to the bread line then you should avoid high risk/high return investments in favour of safer investments that offer a higher probability lower return.

Diversify your portfolio

One of the key investment tips everyone should apply to diversify your investment portfolio. The old phrase "don't put all your eggs in one basket" still holds strong. In practical this would mean that you spread your investments across a wide range of asset classes, for example shares, corporate bonds, government bonds, property etc. Even on a micro level you can apply the same theory so that any shares you do buy should be spread across several sectors. The benefit being if one sector or asset class performs particularly poorly compared to the others, your losses will have been diluted by your holdings in others.