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Do you really need risk in your portfolio?

First let’s establish that we invest our money in the hope of a return. Risk, is the chance that instead of a positive return on your investment, you end up losing money or get a return lower than anticipated. There is no real risk-free investment.

With all that’s going wrong in the financial and physical asset world, gold has made a shining come back. It will be a mistake though, to shy away from financial assets and move to safe havens like gold because of the lower returns in recent months. While gold is a good store of money, it won’t help you create wealth in any significant manner. For creating wealth, you need risk.

Why do you need risk?

First let’s establish that we invest our money in the hope of a return. Risk, is the chance that instead of a positive return on your investment, you end up losing money or get a return lower than anticipated. There is no real risk-free investment. 

Government issued securities are considered risk free. However in some countries even the government has defaulted on pay outs for bonds issued. 

Thankfully, we don’t face that risk here and Indian government securities may be considered risk free.  The payment is a regular interest, which you know in advance and, the issuer is trusted. This risk-free interest rate today is roughly 6.8% per annum. This also means that, if you want to earn anything more than this return, you will have to take on some risk. 

Thus, return earned is bound by risk taken. Bank deposits are low risk, hence, offer a relatively low return compared to market linked securities like debt mutual funds. In order to achieve the 7%-7.5% returns from liquid funds and approximately 8%-8.5% from short term debt funds, you have to take on some risk of near-term volatility in daily net asset values (NAVs). 

Take it up a notch, equity stocks and mutual funds have the potential to deliver 10%-12% annualised return over a period of time. However, there is no regular interest pay-out involved, making them riskier than bonds, deposits, and debt funds. 

Not all risk will lead to potentially higher return. If someone is guaranteeing a return of 12% annually; can it come without risk? No. The risk could be unreasonably high. Why? Firstly, the return is guaranteed and secondly, it’s a relatively high number when you consider the risk-free return. That kind of risk can make you lose your money. 

In order to grow your wealth you will need a return higher than the risk-free return, something that beats long term inflation, and is tax efficient. This is achieved by equity investments. What is important is to remain invested through periods of turmoil so that you smoothen out the risk that comes from daily volatility. For debt assets which are market linked, you need at least 2-3 years and for growth assets like equity and real estate, you need upwards of 5 years for expected returns.

All risk is not good

Not all risk will lead to potentially higher return. If someone is guaranteeing a return of 12% annually; can it come without risk? No. The risk could be unreasonably high. Why? Firstly, the return is guaranteed and secondly, it’s a relatively high number when you consider the risk-free return. That kind of risk can make you lose your money.  

If you take a risk on quality of the product, stock or bond issuer, the likelihood of losses increases, and no matter how long you remain invested, you are prone to losses. 

Hence, check the quality of the underlying company who is issuing a bond to you or whose stock you are buying. A bad quality issuer is high risk, even if the payments to be paid are in the nature of fixed interest pay outs. Similarly, an investment made in a company with falling revenue and profits is unlikely to yield you any gains. 

Lastly, a poor-quality debt or equity fund manager, will also fail you. Do your homework thoroughly on the quality of your investment. 

Don’t be afraid to take risk, just ensure it’s the right kind.

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