What is investment risk and how do I determine what is an appropriate level of risk I can tolerate?

Investment risk has many complicated and mathematical definitions. To simplify those concepts, we will concern ourselves with one very simple definition: investment risk can be defined as the probability of losing  the principal amount of one’s invested money.

Elphinstone advises clients to select portfolios based on the level of risk that appropriate to their savings needs. What does that mean? It means that you should decide on how much risk you can take based on how long you are saving your money. The longer you can save money, the more risk you can reasonably take, and thus earn higher returns. The shorter you are saving money for, the less risk you can take, and thus expect lower returns.

For example, if you are 30 years old and saving for retirement at age 65, you have 35 years left to save, and therefore can take quite a bit of risk, since you can reasonably expect the market to recover from any downturns in might experience over the next 2-3 years over the next 35 years. If, however, that same 30-year-old is saving to buy a car in three years, they can afford to take a lot less risk, since market volatility during that period could cause a loss of principal that they would not have time to recover from before they need the money.

As a result of this basic principle, Elphinstone has devised five simple risk levels – each corresponding to an appropriate portfolio – for our clients. There are Islamic and conventional portfolios at every risk level.

Here is some additional information about them:

Composition: The composition suggests what proportion of the portfolio consists of stocks (either Shariah-compliant S&P 500 ETF or conventional S&P 500 ETFs), and what proportion consists of fixed income securities (either investment grade, dollar-denominated sukuks, or short-term and variable rate US government bonds).

Recommended investment horizon: This is the time period for which we believe the portfolio would be appropriate. For instance, investors who are planning to save for 10 years or more can invest their money in the Fortune Building portfolio, but those saving for under 5 years should not do so.

Average returns of benchmark portfolio: Using historical data for the 10 years ending December 31, 2022 for the S&P 500 to represent stocks and US government bond indices to represent fixed income instruments, we calculated what the returns would be for each investment portfolio that was invested in the benchmark portfolio, gross of fees.