The risk and return trade-off

Simon Hoyle,  Editorial,  No More Practice Education

If you think that owning shares in each of the four big banks represents diversification and reduces the amount of investment risk in your portfolio, think again.

BlackRock head of Australian fundamental active equities Charlie Lanchester says an over-exposure to banks – and to the same risks as affecting those banks – is one of the biggest issues currently facing Australian investors.

Failing to properly diversify, and having too much money exposed to one stock, one sector or one risk factor, is called “concentration risk”, and investors should avoid it.

In a new Money Masters interview, Lanchester says economic factors – like interest rates – that can affect property investors also can affect the banks, which lend money to those same investors, and what investors should be thinking about to avoid unintended or hidden risks.

“Increasingly, the four banks are as one, and very much focused around the same theme,” Lancaster says. “At the same time…many investors in Australia have investment properties as well, which is effectively the same trade.”

A typical retail investor’s share portfolio is invested heavily in the big four banks, Lancaster says. But the aim of diversification is to ensure that no single stock or sector or risk can unduly affect the overall value of the portfolio.

Some components of a portfolio should perform well when others are not, to help minimise volatility – or the variability of returns – and to help make sure that for a given level of investment risk an investor is getting the best possible return. Or, conversely, that in achieving a particular return, an investor is not taking too much risk.

Getting this risk and return trade-off is the holy grail of successful investment.

 

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