Here is a quick primer on what RISK means in context to your investments. Usually, we only talk about returns. What kind of returns to expect? How much return you need? Which product to invest in to get the adequate return?
However, risk is less talked about. Nevertheless, no investment comes without risk. You may think that investing in a bank fixed deposit is a risk-free experience, but it is not. The risk there is inflation risk. The risk that you will not make returns enough to cover the damage done to the value of your money through the natural annual inflation in the economy.
Similarly, there are many risks in market-linked investments like equity mutual funds.
The notes below will familiarise you with some of the risks that investments carry and what you can do to manage these risks.
1. What is RISK?
In investing, risk comes primarily from these four aspects –
Inability to sell your investment – Liquidity Risk
Possibility of capital loss – Market Risk and Quality Risk
Possibility of returns lower than annual inflation – Inflation Risk
Focus on a few securities only – Concentration Risk
Specific portfolios can have additional risks, in general, if you are an active investor, these are some standard risks that all portfolios face.
2. Risk that YOU have to bear
The good news is that all the risks above can be managed through various financial planning tools, however, there is one type of risk which you will have to bear. This is Market Risk. Market Risk is essentially the sudden shift in sentiment which can lead to sharp swings in prices of listed securities like equity shares, listed bonds and mutual funds. It impacts the immediate return on your portfolio and is highly unpredictable in a short time frame of say 0-3 years.
There is no way to avoid this risk when you have a portfolio of long-term investments which need to be held for more than 5-10 years. What you can do to manage the impact better is indulge in asset allocation, planning and patience.
3. Risks which can be managed
Liquidity Risk – Invest in open-ended mutual fund and tradeable stocks and bonds which can be exited at any point in time.
Inflation Risk – Don’t put too much money in low return fixed income securities like bank deposits. Invest in equity assets to ensure inflation plus returns in the long term.
Quality Risk – Do your homework, research to ensure that the funds or stocks you buy are backed by good, reliable and consistent management. If this is not a task for you, then use your energies to find a good quality, reliable and trustworthy financial advisor.
Concentration Risk – Diversify your portfolio across more than one type of asset, product and even fund manager. But keep only one advisor!
4. Why do you need risk?
If all this talk about risk is making you nervous and you feel that you needn’t take on risk in your investments, think again. Without adequate and calculated investment risk you will bear the big burden of inflation risk – or not growing your money enough in the long term to beat inflation. If that happens the value of your money is falling not increasing. To have inflation plus returns you have to take on some of the risks we spoke about above.
5. Return comes from risk
Unless there is some risk, return does not increase. Think about it, if we were able to make high returns from risk-free investments everyone would be buying only one type of investment. However, that is not possible. Investing in products like bank deposits might seem risk-free, but as mentioned above, you risk devaluing your money and destroying wealth in the long term.
What is important, however, is not taking high risk, rather you have to add the right kind of risk.
The right kind of risk and proper risk management through financial planning is what will ultimately help you in creating long term wealth. You can’t always avoid risk, it’s better to understand the type of risk you’re taking and prepare yourself to manage it in the best possible manner.