When considering an investment option, one of the most fundamental rules is that risk and return go hand in hand. The desire to strive for a higher investment return will undoubtedly require you to take higher risk. There is no exception to this rule.

Over the long term, there is no avoiding risk. Even for an investor that is extremely risk averse and finds greater comfort holding cash, this lower risk, “safe” investment option will almost definitely generate a lower return and will be unlikely to offset the effects of inflation over time. As a result, minimising investment risk has increased inflationary risk, and subsequently the likelihood of running out of money.

At the end of each financial and calendar year, we are bombarded with data on the best performing super funds. The only measure these reporting agencies seem to acknowledge is the top line return, without any reference to the level of risk that investors have taken to achieve such returns. Investment options such as balanced, growth, and conservative may share a name across funds but there is no consistency with investment strategies, and risk can vary considerably.

For example, many investors may simply go with the ‘Balanced Investment Option’ with the belief that exposure to growth assets such as shares, and property will be offset by a relatively equal exposure to more defensive assets such as such cash and fixed income. However, when looking at some of the largest industry super funds in Australia, many may be surprised to see that the average exposure to growth assets in their balanced investment options is around 75%. Perhaps not as ‘balanced’ as many would assume.

So, if we can’t avoid risk, what are our options?

Risk cannot necessarily be avoided, but it can be managed.

When designing an investment strategy, greater thought should be given to what return is necessary to achieve your objectives, and therefore what risk you may need to take, rather than simply focusing on returns.

Investment risk is managed via diversification, where your portfolio is spread across various asset classes. This approach not only provides the opportunity to benefit from what each asset class can provide, but it is also proven to smooth returns over time, as no single asset class will dictate performance.

Also, it is important to separate ‘investing’ from ‘speculating’. Investing is buying a high-quality asset that has the potential to generate a solid return over the long term. On the other hand, speculating is more focused on higher returns over shorter time frames. However, like gambling, the risk of capital loss is extremely high.

So, the next time you see the return from an investment, perhaps take some time out to understand the risk. At the same time, when you are uncomfortable taking any risk, consider what the long term implications may be and how the purchasing power of your capital may be eroding.