Risk comes from not knowing what you are doing – Warren Buffet
Risk is a scary word, but unlike ghosts, it does exist. On top of it, risk is omnipresent. But one needs to learn how to tide over risks to reach the shores of rewards. For that, one needs a sturdy boat. Knowledge is the wood that can be used to build such a boat.
In terms of investments, knowledge is the key to identifying risks so that we devise mechanisms to mitigate them and reap the corresponding rewards. Knowledge is also the magnifying glass through which we examine the identified risks to understand their ramifications that can put an obstacle in our way to the desired investment rewards. Knowledge is also the torchlight which we can use to look for previously unidentified risks that can be detrimental to our financial progress. We’ve discussed a few critical pointers in this regard which you’re likely to find helpful.
Identifying different types of investment risks
Every pragmatic investment strategy needs to be preceded by the identification of short, medium and long-term financial goals. However, these time-bound goals can get hurt by different risks if we fail to factor them in. Some of the prominent investment-linked risks are:
a) Inflation: Prices of things increase with time. If you do not factor in the impact of inflation on your investment returns, you will find it difficult to reach your financial goals on time, or worse, miss your targets by a long margin.
b) Illiquidity: If all your money is invested in tools that come with long-term lock-ins or whose premature liquidation leads to capital loss, addressing unexpected or short-term financial requirements can become very tough.
c) Volatility: Market-linked investment instruments are prone to volatile phases due to a host of external reasons that may deplete their returns and undermine your financial objectives.
d) Emergencies: Unexpected incidents like a sudden job loss, a family emergency or a medical emergency can throw even the best of your investment plans out of gear if you’re unprepared to tackle them effectively.
e) Excessive adventurism: Without the knowledge of the intrinsic characteristics of different investment tools, you may unknowingly take undue investment risk that can jeopardise your financial goals.
f) Counterproductive conservatism: The inability to understand the real risk of not taking any investment risk (or not investing at all) can lead to inadequate wealth-creation or unfulfilled financial goals.
Understanding the difference between your risk appetite and risk tolerance
Risk appetite is your willingness to take investment risk. Things like your age and expertise over investment instruments ideally determine your risk appetite. For example, it’s said that young investors have a greater risk appetite than those nearing retirement age. Similarly, expert investors can understand the market trends better and hence can afford to take more risk.
Risk tolerance, on the other hand, is your actual ability to take investment risk. Things like your income, liabilities, debt and insurance situation determine your risk tolerance. For example, you may be young and hence think you have a high-risk appetite. But let’s assume you’re also struggling with a snowballing credit card debt that doesn’t leave you with sufficient funds to make any investments. In this case, your risk tolerance will be low even if you have a high-risk appetite. On the contrary, if you’re a young high-earning professional with limited financial liabilities and an adequate insurance cover, you can actually afford to take a lot more investment risk to garner better returns as your risk tolerance will be high. Thus, it’s critical to understand your risk tolerance along with your risk appetite to grasp the requirements of your financial goals and make smarter investment moves to achieve them on time.
Ways to mitigate investment risks and get expected returns
There are a number of things that you can do to minimise the impact of different risks that can hurt your investments:
- Increase awareness and research: Reading investment-related books and articles, increasing awareness about different macro trends, consulting a financial advisor and comparing your options will help you to build informed investment perspectives that can minimse the impact of risks and fulfill your financial goals. Avoid making major investment decisions based on hearsay or in a rush.
- Go for optimal diversification: Spreading your investments across different instruments and asset classes with varying degrees of risk and rewards can minimise the overall risk that your investment portfolio carries. You should ideally build a diversified portfolio with several low, medium and high risk investments factoring in your income and liquidity requirements to ensure you meet all your financial goals in a timely manner. That being said, when diversifying, do not get overboard and invest in too many instruments at the same time whose total risk-reducing benefit might be lower than your expected loss of returns. Understanding the requirements of your financial goals is paramount.
- Start investing early: The longer you stay invested the more time your investments get to absorb the shocks of market volatility and fetch desired returns. Besides, starting early allows your investments with ample time to grow — thanks to the power of compounding.
- Make good use of established strategies: There are many tried-and-tested risk-correcting measures that you can benefit from. For example, when it comes to mutual fund investments, it’s better to go for a Systematic Investment Plan (SIP) than a lump-sum investment (unless you know when to time your investments). SIPs allow the benefit of rupee cost averaging that can mitigate the risk of market volatility and fetch good returns in the long-term. Similarly, setting informed stop-loss and take-profit orders can help better control investment risk in stock and forex trading.
- Weave a strong safety net to protect your investments from the risk of emergencies: Take steps in advance to prevent draining of precious savings and investments while tackling an unexpected event. These include building an adequate emergency fund (worth at least 6 months of your expenses), getting comprehensive health insurance cover for yourself and your dependents (worth at least Rs. 5 lakh if you live in a metro) and purchasing a life insurance policy (worth at least 10 times your current annual income).
In conclusion, smart and consistent investments are keys to creation of wealth and fulfillment of life’s aspirations. And informed investment decisions cannot be made if one doesn’t know how to mitigate the associated risks. Educating yourself on demystifying these risks is the key.
The writer is a Content Manager with BankBazaar.com, India’s largest online marketplace for loans and credit cards.