Liquidity, Risk and Diversification

Good morning Mumas,

Welcome to this post.

This will be the first of a three-part series that hopes to tell you the basics of investing.

In this post, you are going to be introduced to the basic characteristics of investing and the names of various investments and their basic features.

First, we will look at Liquidity, risk and diversification 

So, let’s start with Liquidity.

Liquidity refers to how quickly a financial asset can quickly be turned into cash. Think about a current account or credit card where you can immediately turn the money on your card into cash.

There are a few pros: 

  • You can use it to pay for things immediately such as groceries, a period of unemployment and an unexpected home repair 
  • It’s safe and low risk

However, there are a few cons too:

  • There is a low or non-existent rate of return 
  • Easy access to money creates temptation – when money starts to grow in our current accounts we feel the need to spend 

Unfortunately, there is a trade-off between ease of access and a rate of interest. We have easy access to our money so, we trade off higher returns. 

Risk

Risk refers to the amount of uncertainty about the value of an investment in the future. We tend to like liquidity and the ease of access, however, most of us don’t like risk. When we buy an asset such as stocks or bonds, we expect the value to increase in the future. This is called our return on investment. In simple terms, risk refers to not knowing what the payout will be. There is a greater risk of losing your money in the higher and more unstable and volatile market, however, there is also a chance that your money will bring in a higher return than if you went for a less risky investment.

Here are the pros and cons of risk 

Pro

– there is a possibility that the higher the risk the higher the payout on your investment 

Con 

  • You may get back less than you invested 

Let’s see risk in action 

Imagine you have 10,000 to invest, how much less happy would you feel if you lost money and only got 5,000 back on that investment? How much more happy would you be if you received 40,000 back? Would you be willing to take a 50/50 chance of receiving the higher or lower amount? That’s risk tolerance in action. 

There are safer ways to invest these investments are for the risk-averse. Being risk-averse means that you are not comfortable with risk and you would rather be 100% sure that you will get back more than you invested.

Investments for the risk-averse include government bonds. For example, imagine that you buy 5000 in government bonds when you are 30 you expect to turn into 25,000 over 30 years. When you are 60 you will have earned 5.5% on your investment. This is what is known as a risk-free rate of return.

Let’s dig deeper and look at the different types of risk. There are 2 key types systematic and unsystematic.

Systematic risk 

Systematic risk is the risk involved in investing in the overall economic system. This is the risk that comes from the overall swing of the economy from recession to expansion. This type of risk can not be removed.

Unsystematic risk 

Unsystematic risk is the risk you acquire whilst investing in individual stocks. This risk is firm-specific and is unique to the company in question. For example, a major natural disaster affecting a clothing company you have invested in.

To manage risk we can diversify.

Diversification 

Diversification refers to a mix of assets in your investment portfolio. Individual stocks tend to be very risky and volatile. By combining and mixing your assets you can reduce the overall volatility and instability of the market and reduce your risk. For example, if half your stocks go up after a year and a half go down in value, your portfolio may not be affected.

We aim to have a diverse portfolio of investments to mitigate risk and ensure we ….. our investments.

This is where this post comes to an end. You should now have the basics of investing and in the next post, we will dig a little deeper and look at financial instruments.

Before we get there though, I’d love to hear your feedback on this post.

Did you learn anything new?

Have I sparked your interest in investing? 

Do you know where to get more information?

The content shared in this blog is for informational purposes only. You should not construe any such information or other material as advice in a legal, tax, investment, financial, or other sense. You should consult a suitably qualified, independent adviser before making any financial decisions.

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