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Making sense of risk and why we need it

There are many such examples of risk-return trade off which we make consciously in our daily lives. In investing too there are varied types of risks, to achieve your return you have to know which ones to take and which ones to avoid.

Let’s say you are on a weight loss diet, eating mostly salads and uncooked food for a week now. The objective is to lose 3 kilos in a month. There is a dinner invite that you can’t turn down; you reason that one dinner is not going to do too much harm to your diet and go for it.

What you have done, is decided that one night of food indulgence is not a big risk to your diet. Let’s say instead this was 3 or 4 dinner invites, is your diet regimen at a greater risk? Probably, yes. 

If you indulge in all four, you are likely to miss your weight loss target. In other words, you took high risk and were unable to meet the return expectations. 

This is one side of risk. But think about it a bit more; changing your regular food habits to sustain only on salads, isn’t that a risk too? You could face under nourishment and fall sick. However, if you have planned it well, calculated the nutritional impact of the salads, its perhaps a risk worth taking to get in shape.

The risk of eating only salads vs the risk of eating rich food at dinner parties, are two completely different types of risk, but both matter to the final outcome you set out. 

There are many such examples of risk-return trade off which we make consciously in our daily lives. In investing too there are varied types of risks, to achieve your return you have to know which ones to take and which ones to avoid. 

Volatility

In simple terms it refers to fluctuation in price of securities. It becomes relevant when you hold market linked investments like mutual funds, shares and listed bonds. There is a daily price published and this is influenced by a number of factors. External factors like immediate demand and supply of the security, the market sentiment, interest rate announcements and so on impact the daily price of securities.

This creates volatility and uncertainty in the near term. However, in order to achieve your long-term return expectations, some amount of near-term volatility has to be endured. 

This is a bit like the risk of eating salad every day; when you just start out, you will find changes in your metabolism which you are unfamiliar with and seem uncomfortable.  Over time though, the body adjusts and you begin to see the benefits of a healthier lifestyle. Every individual’s threshold differs; hence, the diet plan will be different too.

In investing, understand the degree of volatility that you can absorb in the short term to fulfil your long-term return objective; this level of risk will differ for each investor. Asset level diversification and remaining invested for long period (in the right investment) will help you manage this risk better. 

Quality

Internal factors such as the issuing company, quality of management, underlying financial health and quality of fund manager (in case of mutual funds) have an impact on the long-term expectations rather than the immediate daily price. 

Going back to the salad analogy, if you don’t calculate the nutritional value of the ingredients, you are putting your health at risk over time. However, you also need to get on the diet if your weight is too high and poses other health risks. 

Risking the quality of your investment or investing in products simply for the sake of return without checking up on other internal factors can be detrimental to your portfolio. Will you go for a weight loss powder that promises 10 kilos weight loss in 10 days? Immediately, you know that the promise is hard to maintain and unlikely to come without side-effects.

Investing is no different; if the return expectation is too high, the risk of capital loss is also high. You must check the source of return, the quality of management (company or fund) who are going to deliver this performance. Product level diversification can aid in balancing this risk across your portfolio to ensure that not all your capital is subject to volatility.   

Taking risks are a part of everyone’s life. In investing too without adding the appropriate risk, you will not be able to create long term wealth, but if you take on too much risk then be prepared to face the adverse consequences.  

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