One of the most important steps to creating an investment portfolio is to start by defining the levels of risk that you are comfortable taking. By understanding the levels of risk that you comfortable taking and the rate of return required to achieve your goals, you will be able to build an investment portfolio that is appropriate for your goals while still being able to sleep soundly at night.
Financial risk is defined as being the chance that investors will lose money. I prefer to define financial risk as being the chance of permanent loss of capital. Investment over the long term is very different to short term speculation.
For a short term speculator or trader as they are more commonly known as, the risk of permanent loss of capital is significantly more likely as the trader routinely looks to enter and exit positions. Generally over the short term markets move based more on sentiment and how investors feel about the market than from a fundamental perspective.
As far as long term investors go, there is no bigger or more famous than Warren Buffet. For the Oracle of Omaha the goal is to make quality investments that if the market was to immediately close tomorrow and not reopen for the next 5 years he would still be comfortable with his investments. This enables him to sleep soundly at night knowing that the short term movements in the market will not adversely affect the true (or intrinsic) value of his assets.
Risk in financial markets can be created from a range of areas including; currency, liquidity, political, speculative and asset specific risks. It should also be mentioned that as our population ages due to the advances of modern medicine there is now a longevity risk or the chance that you could outlive your money.
Markets are constantly moving up and down with different assets moving in their own unique ways. Academics and advisors have preached about the benefits of diversification for years as it allows an investor to not hold all their eggs in one basket.
A big part of this involves holding a mix of assets including cash, fixed interest, property, shares, commodities and alternative assets. One of the most common mistakes investors make is although they might hold a range of asset classes they are still exposed the to same risk factors.
Hypothetically, if I was to hold an equal allocation to the following investments: an ANZ Term Deposit (cash), an ANZ Capital Note (Fixed Interest), owning the building that is tenanted by an ANZ branch and some ANZ shares, this portfolio although holding a range of asset classes could not be considered diversified as all assets are influenced by the same underlying risks.
My two top tips to creating a portfolio that will enable you to sleep soundly at night is to invest in assets that you understand and to not take more risk than you are comfortable taking.