An investment truism is that risk and reward are interconnected. In other words, if an investment is deemed risky then it must carry sufficient potential reward to compensate the investor for taking those risks.

Unfortunately as chartered accountants we see people taking investment risks without fully understanding the risk/reward relationship, or how it may work for/against them.

Risks are increased through: 

• Borrowing to make an investment
• Lack of knowledge 
• Failing to “do the numbers” or manage the ongoing investment 
• Not taking expert advice when needed (investment opportunities, markets, ownership structure, tax etc) 
• Buying/selling on emotion 
• Not diversifying 
• Chasing “hot” investments 
• Trying to “time” the market (and trading) 
• Failing to “cut losses” at an appropriate point, and not riding the profits 
• Lack of an overall plan/rules that suits the individual investor

Conversely, potential rewards are increased through:

• Leveraging an investment
• Specialised, niche market knowledge (yours or a professional) 
• Counter cyclic investing strategy 
• Analytical, non-emotional approach 
• Sound investment rules and strategy (including exit strategy) 
• Ongoing investment monitoring and review 
• Understanding opportunity cost (by making one investment you are often precluded from making a potentially better investment) 
• Ability to handle volatility and uncertainty – linked to your investment confidence, personality and knowledge

If an investor develops specialised market knowledge then they can reduce risk and increase potential rewards by “sticking to their knitting”, and doing what they know (assuming they get it right!).

Most of us are aware of investors and business people who have achieved outstanding financial results mainly through their expertise, persistence, and specialised niche market knowledge – think Warren Buffet, Bob Jones, Bill Gates, et al. These are highly sophisticated investors who developed expertise, stuck mainly to markets that they knew, and reaped the rewards.

However, most of us are not Buffets, Jones or Gates. In fact, most of us are focussed on bringing up our kids, keeping our important relationships alive, staying healthy, doing the best we can in our everyday lives. Maybe we don’t have time / inclination / personality resources / ability or whatever to develop the knowledge necessary to become specialised niche investors.

Most of us are probably “average” investors. So what’s the best strategy for an “average” investor?

In our opinion an “average” investor will do best by taking a balanced strategy – one that limits their risks, probably won’t reap excessive rewards, but they will be able to sleep at night, they will feel comfortable with their investments, and they will achieve financial independence within a reasonable time frame through diversification, patience, discipline, persistence, and regular saving and investment.

So what is a balanced strategy?

Utilising a balanced investment strategy is like building a pyramid – build solid foundation assets first then low risk investments (Plan A), then medium risk investments (Plan B), and finally higher risk investments (Plan C - optional).

Plan A is your plan to be safe, plan B is to be comfortable, plan C is to be rich. Beyond plan C its pure adrenaline and fun! (but only go there if you can afford to lose this money!!).

If you start at the top of the pyramid and invest in higher risk investments without a solid foundation, low, and medium risk investments in place… that is speculation, not an investment strategy. If your speculation fails you will be left with nothing. Unfortunately, this is what some investors do – and they get burnt, lose everything, and sadly they have to start the game again.

The investment pyramid looks a bit like this :

The investment pyramid shows that owning your own home is a foundation and security “asset”, residential rental real estate is part of your Plan A to be safe, commercial real estate is usually medium risk (Plan B to be comfortable), short term land transactions are usually higher risk (Plan C to be rich), while land speculation is highly risky and adrenaline packed (and capital gains are taxable)!

Understanding the true nature of the property deals you are considering in relation to the investment pyramid is beneficial. Remember, high potential rewards generally carry high risk.

Always ensure that the potential investment rewards are adequate to compensate you for the investment risks you are taking. And that you can afford to take those risks.