Financial Concepts
Build Your Knowledge
Wondering about key financial concepts that you must know about before investing? We’ve got you covered through our in-depth take on the most important ones.
Learn more about risk, return, diversification, asset allocation etc. To help you make more informed decision with regards to your investment.
The Risk Return Tradeoff
As an investor, what risk level is most appropriate for you?
Risk tolerance differs from person to person. It depends on goals, income, personal situation, etc. Hence, an individual investor needs to arrive at his own individual risk-return tradeoff based on his investment objectives, life-stage and risk appetite. Deciding what amount of risk you can take while remaining comfortable with your investments is very important.
Risk, measured in statistics by standard deviation, is the chance that an investment’s actual return may be different than expected. Practically, with high risk you have the possibility of losing some or even a large percentage of your original investment.
Low risk mostly leads to low potential returns. High risk is associated with high potential returns and losses. Higher risk does not always lead to high returns. The risk-return tradeoff is an effort to achieve a balance between the desire for the lowest possible risk and the highest possible return.
Diversification
Diversification refers to spreading your investments across a variety of Shariah-compliant assets to reduce the impact of any single investment on the overall performance of your portfolio. The core objective is to minimize risk while striving to preserve and grow wealth in a halal manner.
You can achieve diversification by:
- Allocating your portfolio across multiple permissible asset classes, such as Islamic equities, sukuks (Islamic bonds), Shariah-compliant mutual funds, Islamic bank deposits, and real estate.
- Selecting investments with different levels of risk, so that potential losses in one area may be offset by gains in another.
For instance, a diversified Shariah-compliant portfolio might include a combination of stocks, sukuks, and Islamic deposits. One practical approach is to invest through a mix of Shariah-compliant mutual funds—for example:
40% in equity funds,
30% in sukuk or Islamic income funds, and
30% in Islamic money market funds.
While diversification cannot guarantee protection against all losses—as all investments carry some level of risk—it is a prudent strategy aligned with Islamic financial principles to help you achieve your long-term financial goals with reduced volatility.
Asset Allocation
While understanding risk and diversification is essential to sound investment decision-making, it is equally important for investors to optimize their portfolios by selecting an asset allocation that aligns with their personal risk profile and investment horizon—all within the framework of Shariah compliance.
This involves choosing between various halal asset classes such as Islamic equities, sukuks (income-generating fixed-income alternatives), Islamic money market instruments, or even capital-protected Shariah-compliant investment products. With the guidance of qualified investment professionals, investors can determine the appropriate level of exposure to each asset class based on their financial goals and risk tolerance.
Over time, an investor’s risk profile and investment horizon may evolve due to changes in wealth, life circumstances, or financial objectives. As a result, it is crucial to regularly review and adjust asset allocation to ensure that the portfolio remains well-balanced, Shariah-compliant, and aligned with the investor’s long-term aspirations.
