You can lower the risk while investing in market-linked products by optimal diversification and opting for systematic investment plan. Investing for the long term can also lower the risk to a great extent
Market-linked investment instruments play a crucial role in accomplishing investors’ financial goals, maximising their wealth creation and beating inflation in the long term. Depending on the age, risk tolerance, return expectations and goal requirements, one should smartly allocate an adequate portion of the portfolio into market-linked instruments. For example, if you are a young investor with a high risk appetite, limited liabilities and an ambition to build a huge corpus for your future, you can’t ignore market-linked investments.
Now, depending on the underlying asset class, a market-linked investment can be a debt, equity, or hybrid (i.e. mix of debt and equity) product. However, in a bid to earn greater returns through market-linked investments, one cannot ignore that they also carry greater risk in comparison to non-linked instruments like fixed income instruments. So, you should be aware of these crucial things before investing in a market-linked instrument.
Types of market-linked instruments
Some of the popular market-linked instruments available in the market include mutual funds, unit-linked plans (ULIPs), direct equities and the National Pension Scheme (NPS). These market-linked instruments could offer a high return, but they also carry a higher risk in comparison to a fixed income product. If you are a risk-averse investor, you should avoid investing only in market-linked instruments.
Who should invest
If you are young, have limited liabilities, and ready to take a higher amount of risk to generate greater returns, a market-linked instrument can be an attractive investment option. Even older investors with limited liabilities and healthy finances safeguarded by, say, adequate insurance protection, could also consider smartly investing a small portion of their funds into market-linked products. Market-linked instruments can beat inflation and generate a high real rate of return (i.e., nominal returns minus applicable taxes, investment charges, etc.).
However, if you are looking to chase a crucial goal in the short term, you may want to avoid investing in a market-linked instrument. It’s usually safer to invest in a market-linked instrument to achieve long-term goals. Also, some of the debt-oriented market-linked investments are comparatively less risky than equity-oriented market-linked investments.
How to lower the risk?
You may lower the risk while investing in market-linked products by optimal diversification and investing through the systematic investment plan (SIP) method. Instead of investing the entire corpus in a single market-linked instrument, you should diversify it into different types of instruments involving different asset classes. For example, you may invest money in equity mutual funds, debt funds, etc. You may further diversify into different types of schemes offered by different companies within the equity and debt fund categories.
Diversification helps in reducing the market risk and minimising the volatility impact on the portfolio. Investing in market-linked instruments through SIP can reduce the volatility risk and allow the benefit of rupee cost averaging in the long term. Selecting the right combination of instruments as per your financial goal, and risk appetite can further reduce the level of risk.
Invest for short-term or long-term
As market-linked instruments have higher exposure to market risks, investing for the long term can also lower the risk to a great extent. However, a product like a liquid fund carries comparatively lower risk than most other market-linked instruments. It can offer you great flexibility and moderate to good returns as a short-term investment instrument. If you are looking for a higher return and don’t have liquidity constraints, go for a long-term horizon when you invest in a market-linked instrument.
How much should you invest?
Investment allocation should always be in sync with your financial goals and liquidity requirements. Market-linked investments have better potential to provide a promising return in the long term compared to short-term investments. People who invest their entire money in a market-linked instrument may suffer losses if they have to exit the investment in the short term due to a liquidity crunch.
So, it would be safe to argue that it is better to invest that portion of your savings into a market-linked instrument that you will not require in the short term. That said, allocation to market-linked instruments should be higher when you are young, and it should gradually decrease as you grow older.
The writer is CEO, BankBazaar.com