Risks

As a general rule, no investment is risk free and all financial investments are subject to market laws. Investors aiming for higher returns automatically increase their risk exposure. The success of an investment closely depends on its strategic orientation, and the potential for high returns increases with the probability of loss.

Funds exposed to equities or foreign currencies represent a higher degree of risk. Since price fluctuations can be significant, the investor who chooses risky assets needs a longer investment horizon. Studies indicate that investors holding risky assets over more than 8 years are rewarded with above-average returns.

Risks also vary from fund to fund. A fund's risk is quantified in terms of volatility: the more marked and frequent its price fluctuations, the more the fund is volatile and exposed to risk. Each fund is characterised by a specific level of volatility that largely depends on the type of assets and the region it invests in.

As a general investment rule, the higher the risk, the higher the potential for gains (or losses) will be. The lower the risk, the lower the gain/loss potential. This is called the risk/reward ratio. The most efficient means to reduce a portfolio's overall volatility is to include a variety of investment assets in it.

When deciding which funds you wish to invest in, you must identify the degree of risk exposure you feel comfortable with. The key factors to consider are the following:

• Your investment horizon: The longer you are willing to wait before recovering invested capital, the more suitable an equity investment fund is for you. These funds may be more risky in the short term, but over the long term, they tend to generate higher returns.
  
• Your investment target: Define your personal objectives, whether aggressive or conservative. They will determine the degree of risk you are ready to accept.
  
• Your personal situation: Your age and financial situation are of key importance. If you have children and substantial monthly expenses, the threshold of your risk tolerance is probably lower. If you already have sizeable and relatively diversified asets, you will probably be more capable of weathering future stock-market fluctuations.

There is a very simple test to identify the limits of your risk tolerance: the sleep test. If you have trouble sleeping because you worry about your fund's returns, you have probably opted for funds that are too risky for you.

Your investments should never be a source of worry.

Risk/return profile

In the graph below, five different portfolio types represent different proportions of bond and equity holdings, ranging from a 100% fixed-income exposure to a 100% equity portfolio.

As stocks are riskier than bonds, two observations can be made:

• As the equity weighting in a portfolio rises, risks and rewards increase.
• Inversely, risks and rewards decline as the portfolio's fixed-income exposure increases.