Risk, Return, Diversification, Liquidity

The world of investing offers a wide range of opportunities to achieve your financial goals, whether you're an experienced investor or just a beginner. But in all cases, one important condition must be met- being informed. You need to be familiar with the specifics of different types of assets and understand a number of concepts and terms. Among them are the following fundamental notions that every investor should know: investment risk, return, liquidity, and diversification. What do they mean?

 

1.      Investment Risk

There is always a risk, and in the world of investing, this means the possibility of losing part or all of the value of your investment. Investment risk arises from various factors, including market fluctuations, poor asset management, or economic crises. It includes risks of different nature:

·         Market risk: This is the risk of losses due to a decline in the prices of financial assets.

·         Credit risk: Related to the possibility that a company may fail to meet its obligations to pay interest and principal on issued bonds or bank loans. In addition to corporate credit risk, there is also sovereign credit risk—this is the risk that a country may become unable to pay the principal and interest on government bonds or other financial instruments issued by the government.

·         Interest rate risk: It concerns changes in the value of investments that are highly sensitive to market interest rates. A typical example of this is bonds. When interest rates rise, the price of existing bonds may fall, because new issues offer higher yields.

·         Inflation risk: This is the risk that inflation will erode the value of income, savings, and investments. For example, if inflation is 6% and an investment in a given product yields a 3% return, the real value of the invested funds—i.e. the purchasing power of your money—will decrease despite the positive nominal return.

 

2.      The Relationship Between Risk and Return

The general rule in investing is that higher risk is associated with higher expected return. For instance, stocks are considered riskier than bonds and usually offer higher expected returns in the long term.

Whether you pursue high returns or not depends on your individual attitude toward the other element of this relationship –risk. Of course, other factors such as your investment goals and time horizon must also be considered.

To determine the most appropriate level of risk for you personally, the following three key aspects are usually examined:

·         Required risk: This is the minimum level of risk you need to take to reach your financial goals. In some cases, to achieve a high return that can exceed inflation and grow your capital, it is necessary to take on greater risk. Understanding this relationship between risk and potential return is critical to determining whether the extra risk aligns with your long-term investment goals.

·         Your risk tolerance refers to your psychological ability to handle fluctuations in the value of your assets. For example, people with lower risk tolerance may feel insecure and anxious during significant, or even moderate, market downturns. Others with higher risk tolerance are willing to endure short-term losses in pursuit of higher long-term returns. When considering an investment, it's important to understand yourself and your own tolerance for risk—after all, you don’t want to lose sleep over your investment. Most management companies, investment intermediaries, and other financial institutions offer questionnaires to determine an investor’s risk profile.

·         Your capacity to take risk refers to your financial ability to absorb losses. For example, if you're early in your career, have stable income, and a long investment horizon, you can afford riskier investments that may yield higher returns. But if you're nearing retirement, a more prudent approach would be to prioritize security over return to protect your funds and ensure future financial stability.

 

3.      Liquidity

The liquidity of an asset indicates how easily and quickly it can be sold and converted into cash without significantly deviating from its market price.

A typical example of highly liquid assets is stocks of large companies, which are traded actively in high volumes every day. This means you can quickly sell your shares to another investor. Another highly liquid investment is mutual funds—you can sell your shares back to the management company at any time. Money market instruments are also highly liquid.

Examples of relatively illiquid assets include real estate and small company stocks—in the event of a quick sale, sellers may have to accept a lower price, leading to a loss compared to current market levels. Life insurance policies linked to investment funds also fall into this category, due to limitations on early termination of the policy.

 

4.      Diversification

“Don’t put all your eggs in one basket” is the most popular expression describing the essence of this concept. Diversification is a key element of investment strategy aimed at managing—i.e.  reducing risk by including different types of assets in the investment portfolio. This limits the dependence of the entire investment portfolio on the performance of a given asset within it. In other words, if one asset performs poorly, the loss from it can be offset by the return from other assets in the portfolio. A key condition is that the portfolio should consist of a sufficient number of investments that are not interconnected, i.e., investments whose performance does not depend on each other.

For example, if an investor puts all their funds into real estate, the value of their portfolio may suffer during an economic downturn, falling property prices, or adverse changes in property-related legislation. However, if the investments are spread across different instruments (such as stocks, bonds, and deposits) and sectors (such as healthcare, technology, and consumer goods), then the decline in the real estate sector could be offset by strong performance in the others.

Diversification can be carried out in various "directions", some of the main ones being:

·         By asset classes: These may include stocks, bonds, cash, deposits, precious metals, real estate, collective investment platforms—mutual funds, exchange-traded funds (ETFs), investments in crowdfunding platforms like P2P (peer-to-peer) platforms, crypto-assets, and more. Each of these asset categories has unique characteristics and behaves differently under various economic cycles and market fluctuations, helping to manage the portfolio’s overall risk. Applying this strategy requires proper understanding and management of a diverse set of investments.

·         By geographic location: Allocating your assets this way is a method to limit losses in case a specific country or region experiences economic hardship. Imagine what would happen to your assets if they were all related to one country and a major earthquake or war occurred there.

·         By economic sectors: Not all sectors in the economy develop at the same pace, and different, complex factors influence their performance. If you've invested in only one sector, the risk of loss is significantly higher compared to a broader, balanced allocation of assets across various sectors—such as finance, energy, transportation, mining, pharmaceuticals, high tech, etc.