As every investor knows, there is no such thing as a completely risk-free investment, and the lower the investment risk, the lower the investment return is likely to be. The challenge for investors is to strike the right balance between risk and return, to find investments that give a reasonable rate of return with an acceptable level of risk. The art of investment portfolio construction is to try and find ways to increase the rate of return while maintaining or reducing the level of risk. There are three principal techniques that are used to achieve this goal.
- Diversification
Risk is amplified when there is a concentration of investment in a narrow range of investment types. The remedy is diversification. Diversification can occur with many different portfolio attributes: asset class (cash, fixed interest, property, shares), geographic location (local or global), form (direct investment or investment in funds), fund management style (active or passive) and so on. The right balance needs to be struck with diversification. Too much diversification results in average returns.
- Rebalancing
A portfolio needs to be responsive to market conditions in the short term to move slightly away from investments with higher short term risk and towards investment opportunities that have the potential for higher return in the short term. Rebalancing in this way requires a high degree of liquidity and flexibility in a portfolio.
- Time Frame
Providing a portfolio is fully diversified, one of the easiest techniques for managing risk is to plan to invest for a long period of time. The longer the investment time frame, the less risk there is in investing in volatile, high growth assets such as property and shares. Matching the investment strategy to the investment time frame is key to getting the right balance between risk and return.
