When it comes to investing, we first think of returns but one must understand that returns and risks go together. In order to reach the desired corpus, one has to take adequate risks, too. Everyone has a different notion when it comes to risk and the impact risk has on returns generated.
Individuals normally seek to invest their hard-earned income in bank fixed deposits, bonds, gold, etc., all perceived as safe havens. However, they don’t realise that unless hard-earned money is invested wisely, their savings, in reality, could be depleted. In actual terms, they will not be creating wealth but diminishing it. Especially, when compared to returns generated, post-tax and after consideration of present inflation rate.
If one has to list down types of risks that one is exposed to, there is indeed a plethora of them. As far as personal investing and wealth creation is concerned, the two most important risks are volatility and inflation.
Volatility risk
Volatility refers to fluctuations in rates on the daily basis. For instance, daily market and stock price movements which are a result of news and temporary sentiments. However, on a long-term basis, this risk doesn’t have much of an impact on one’s portfolio.
Inflation risk
Inflation risk behaves exactly opposite to what volatility risk does. It may not scare you daily but has a potential to erode the value of money over the time. For instance, the purchasing power of R100 in 1979 has come down today to just R6.
In the short term, we do not realise the impact of inflation. From a longer-term perspective, however, inflation outweighs returns, severely shrinking the purchasing power of one’s portfolio. Sooner or later, you will have to consider this factor, when the requirement of the money which you have been saving up for arises.
Risk management
We have often come across investors making investing decisions on the basis of risk appetite. It is advised to first decide where you want to reach — your financial objective — and then undertake risk management.
Visit your goal sheet. Calculate the rate of return that your portfolio needs to generate to reach the desired corpus and accordingly arrive at your risk needs. Say, if you have R10 lakh to invest now and
targeting a corpus of R40 lakh in 10 years, then your portfolio needs to generate a 14% return every year. A risk-free investment will not deliver that kind of return. Once you know what are your risk needs and relevant risks that you need to take to achieve your objective, freeze on your risk profile.
Map it to your asset allocation strategy
This is very important step as this will determine the effectiveness of your asset allocation strategy. Here, one needs to study the risk-return ratio for each of the asset class and relevance of the same to each of the sub-goals of one’s financial plan. For instance, a risk-free investment will get you only R20 lakh in ten years if you invest R10 lakh today whereas a balanced mix of debt and equity can get you the desired corpus of R40 lakh.
Periodic portfolio reviews are a must. Risk audit is indeed a crucial part where we evaluate how risk taking has impacted the portfolio and fill up necessary gaps. Don’t be too afraid of risks. Having said so, a thorough understanding and meticulous planning in risk management is a must.
Right planning is the key
Calculate the rate of return that your portfolio needs to generate to reach the desired corpus and accordingly arrive at your risk needs. Say, if you have R10 lakh to invest now and targeting a corpus of R40 lakh in ten years, then your portfolio needs to generate a 14% return every year.
A risk-free investment will not deliver that kind of return. Once you know what are your risk needs and relevant risks that you need to take to achieve your objective, freeze on your risk profile.
A risk-free investment will get you only R20 lakh in ten years if you invest R10 lakh today whereas a balanced mix of debt and equity can get you the desired corpus of R40 lakh.
Pradeep Gupta
The writer is co-founder and vice-chairman, AnandRathi, Financial Services