Financial Concepts

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 refers to taking exposure to a wide variety of investments in order to minimize the impact that any single security will have on the overall performance of the portfolio—with the objective of reducing your risk.

Diversification can be ensured via:

• Spreading your portfolio among multiple investment vehicles or asset classes such as cash, stocks, sukuks, Shariah Compliant mutual funds, Islamic bank deposits and real estate.
• Choosing investments that offer varied risk levels to ensure large losses may be offset by other gains.

An example of diversification would be building a Shariah Compliant portfolio of stocks, Sukuks and Islamic bank deposits which is achievable via building a balanced portfolio of investments in Shariah Compliant mutual funds schemes. An example of such a portfolio is 40% in Shariah Compliant equity funds, 30% in Shariah Compliant debt funds and 30%in Shariah Compliant money market fund.

Diversification is not a foolproof guarantee against losses as investing always involves risk, but it is effective in helping you reach your long-term financial goals while minimizing your portfolio risk.

While understanding risk and diversification is essential to  decision making, investors must learn how to optimize their investments by choosing the asset allocation which suits their personal risk profile and investment horizon.

This means investors have to make a choice between various asset classes such as equity, income , money market or even capital protected and then decide with the guidance provided by investment professionals how much exposure to take to each asset class.

Over the years , an investors risk profile and investment horizon may change due to changes in wealth , lifestyle etc hence providing the need to regularly revisit their asset allocation so that it is constantly optimized.