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How To Assess & Manage Investment Risk - Part 1

As investors, what we are really trying to do is to ensure that we have enough money for a goal in the future.

As investors, what we are really trying to do is to ensure that we have enough money for a goal in the future. This goal may be a comfortable retirement, children's education or a big purchase. The risk to us, simply put, is that we will fail to achievethat goal. This may happen because of many different reasons. A practical approach, which we can all adopt, is to know what these reasons could be and what steps we can take to protect ourselves.

The first risk is not knowing what the risks are. Every investment, including the so called safe ones like bank deposits, insurance and cash under the mattress carries risk of one kind or another. I hope that this article will add to your understanding of risk and help you be better prepared.

The second risk is that we underestimate the goal. This usually happens because we fail to take inflation into account. A lakhpati was a big deal in the 1960's when 50 rupees was a good salary (remember the black and white movies and the hero celebrating his first job?). Today it is not. So, you need to make sure that 40 years from now when you're watching a rerun of Vicky Donor, you don't wonder why you thought a Crore was a big amount in 2013! Your goals will increase in value with time and you need to make that inflation adjustment.

Let's assume that we've estimated the goal correctly. We may still not be able to meet it because our corpus did not grow to that amount. This is the third risk.

To achieve a particular goal value, we have three contributing components:

  • How much you invest
  • How much net return that investment generates, and
  • How long you invest for

The three are related. For the same goal you can invest less if your expected return is higher, or if you are investing for longer. To take an example: If you want 115 rupees one year from now, you can do one of the following:

  1. Invest 100 rupees in an investment that gives 15% (Higher return)
  2. Invest 105 rupees in an investment that gives 10% (Higher amount)
  3. Invest 100 rupees in an investment that gives 7% for two years (Longer period). *

Three levers to build wealth

We need to make the choice that is appropriate for us by striking the right balance between our goal, our ability to invest, choice of investment option and the time period. We need to remember that you cannot put 100 rupees under your mattress or into an investment generating 10% and expect to get back 115 rupees. This is a mistake unknowingly made by investors when they focus on only one aspect. Opting for lower return investments will mean that you should be prepared to invest more or for longer. There is no other way.

In the next instalment of this article, I will cover a few more risks:

  • of not getting the expected return
  • of losing your money
  • of not being able to save long enough

Please use the comments section below to tell us how you perceive and understand risk and if there's something I am missing out.

(Part 2 of this post is now available)

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