There is no such thing as an investment instrument with zero risk. When you invest, you have to embrace a certain amount of risk, and that the level of risk varies across asset classes and specific investment products.
However, you may not be aware that the risk rating of a certain investment is determined by its volatility, or the general volatility of its assets. All these make up its risk suitability.
In a nutshell, the more likely the value of the investment is to change quickly and significantly, the higher its risk suitability will be. Keep reading to discover the details.
Why volatility matters
When an investment’s volatility is high, the value of the money that you put in it may go up and down significantly in a short span of time. This means that there’s more chance of you not reaching your goal (or even losing money) as compared to an investment that has comparatively lower volatility.
Of course, the flip side is that there’s also a higher chance of you earning more than you would with the alternative investment. It might also lead you to reach your goal sooner. This is due to the relationship between risk and returns – The higher the risk, the higher the potential return; the lower the risk, the lower the potential return.
That’s where the risk suitability comes in. It lets you know if you can still consider the investment given the amount of risk that you’re comfortable with, taking the potential returns into consideration.
You may be able to make the investment even if it doesn’t match your risk profile, as long as you’re willing to sign a risk waiver. However, this isn’t a step to be taken lightly.
Your time horizon will also play a big role here. The longer you can stay invested, the more likely that you’ll end up seeing your money grow. Just keep in mind that this isn’t a sure thing.
The time horizon also tells you that, ideally, the lengthier amount of time you hold on to an investment, the higher it should pay you back either via interest, coupon payment, capital gains, price appreciation, dividends, rental income, or perhaps all of them if you are diversified enough.
The risk-return relationship
The relationship between risk and returns is something that should be understood by anyone thinking of making an investment. Basically, it states that as the volatility (and risk) increase, the potential returns on your investment also rise.
This makes sense from a practical perspective. After all, investors need to have a compelling reason to place their money in products that have comparatively higher risk, and this is provided by the higher profit potential.
This doesn’t mean, however, that you shouldn’t consider investments that match a lower risk suitability. After all, reaching your goal is your ultimate objective, and it would be great if you could accomplish that while exposing your money to less risk (even if you might end up earning a little less).