The total universe of investment opportunities available to
the private investor is huge and growing.
Stocks,
bonds,
money market instruments,
financial derivatives,
alternative investment products and literally thousands of
different pooled investment vehicles. Where do you start?
Well, the first question you need to ask yourself is: What are
you trying to achieve? In other words, what is your investment
aim?
You need to ask yourself what you are trying to achieve because
different investment products exhibit different
characteristics, both in terms of the returns they offer, and,
crucially, in terms of the risks you incur trying to achieve
those returns.
The risk/return payoff
The basic principle of risk and return in financial markets is
more or less common sense: the higher the rewards offered, the
greater the risks incurred.
Looking at it the other way around, the riskier an investment
proposition is, the higher the potential rewards need to be to
encourage people to take on those risks.
When it comes to risk and return, different asset classes show
dramatically different characteristics. Stocks, for example,
offer the highest return, but, as we will see, they also carry
a high risk of losses. Bonds don't perform as well, but they
offer more stability than stocks (less variability of return).
Money-market returns are relatively feeble, but you will never
lose your initial investment.
The holding period
The final piece of the jigsaw is the time in which you want to
achieve your given return, because not only do different asset
classes exhibit different risk/return characteristics, those
risk/return characteristics change depending on the length of
time you hold the asset - the so-called holding period.
To sum up
An asset allocation strategy is about trying to achieve the
blend of risk and return that is right for you, given your
investment aims and the time frame in which you want to achieve
them.
So, the asset allocation decision will depend on a combination
of:
- the expected level of returns available from each asset
class
- the expected level of risk associated with each asset class
- your holding period - the amount of time you are prepared
to wait to get the returns you want
- and your attitude towards risk
In this section we will look at the different risk/return
characteristics of the key asset classes, but first we need to
understand the idea of average annual real returns.
