The possibility that your money might not grow and could actually reduce is the way most people define risk. While we agree that this is a good working definition of risk, this particular definition does not take time into account. What risk really means is the possibility that you may not meet your goals. Money is simply a means to meet your goals.
You could fail to achieve your money goals for various reasons. These reasons are risks. You should, therefore, know what these reasons could be and prepare for them.
Risk #1. Underestimating your money goals.
You underestimate goals when you don’t cater for inflation, or the annual increase in prices of various goods and services. A lakh is seen as a small amount today. 20 years ago it was a huge sum of money. 20 years from now a crore might be what a lakh is today.
As your goals increase, make sure to consider inflation.
Risk #2. The corpus not growing to the goal amount.
You might have calculated your goal amount correctly, catered for risks, and you also took into account inflation but you still couldn’t reach your goal amount. This is the third risk. Let’s understand why this might happen.
Reaching a goal amount depends on 3 things:
1. how much you invest
2. the actual return the investment generates
3. how long you stay invested
The final amount depends on a combination of the above factors. If you generate higher returns you might need a smaller time period or smaller starting amount. If you expect lower returns then you might need a longer time period.
Rs. 100 is not going to become Rs. 200 in a year if the investment is going to generate 8% net return. So you need to balance all 3 factors to reach your target goal – time, starting amount, and actual returns.
Risk #3. Returns not matching expectations
Expected returns refer to the long term average returns that an investment avenue gives. There are two reasons (which mostly apply to marked linked assets) why returns don’t meet expectations:
a. Right investment avenue but wrong tool:
You might have chosen the right asset class such as equity but the exact instrument you invested in might underperform (such as a bad mutual fund or stock).
Solution: periodic review of the instrument to check how it is performing compared to peers or a benchmark index.
b. The market underperforms right when you plan to withdraw:
You have stuck to the long term investment timeline but right when you want to withdraw, the market tanks. This is of course unpredictable.
Solution: withdraw investments from equity and transfer them to debt as and when your investments are near their target sum. This should be done carefully and only when you have specific requirements for the money.
Risk #4: The risk of losing money
This risk varies across investments and the loss can be invisible (inflation) or very visible (Value goes down). Let's take a look at how this applies to various common investments options:
As we can conclude from above
• No investment is "absolutely safe"
• Each investment has its own unique set of conditions which could cause you to lose money
• Safety of principal is no safety because inflation reduces the value of money
Why not fraud?
Fraud is the one threat that both the government and financial institutions have regulations and guards against. If you are realistic about the returns you expect, fraudsters will find it hard to cheat you.
Risk #5: The risk of not being able to save long enough
This risk is that you couldn’t save for the expected duration or save enough. This may happen due to loss of job, accident, illness, unexpected expenses or death.
This is where insurance comes in. Insurance fills the shortfall in your goals when you are unable to. Health and accident insurance for disease and injury; household insurance for loss of property and life insurance in case of death. As of now, we do not have layoff/redundancy insurance in India to cover job loss.
Remember though, that insurance is not an investment. It is exactly what the name implies, an insurance against your loss of ability to earn, or the loss of your assets. How much insurance you need is driven by what stage of life you are at and what your financial plan is.
Risk #6. Not understanding the true risk associated with a decision
This is essentially a summary of the above points. Risk basically takes two forms.
Short term risk is what we see in the form of changes in the value of what we own – stock prices go down, your home is worth less than what you paid for it, etc.
Long term risk is inflation which reduces the value of your money over time. It’s a “certain risk”. Overcoming inflation is the main reason for investing and why your investment returns should beat inflation. But often, we get scared by the short term “uncertain risk” and instead choose long term “certain risk”.
Remember these 6 tips to make sure you are ready to face risk:
#1. Know your financial goals before starting to invest, do not underestimate them.
#2. Know how much to invest to reach your goals, the rate of return you need to reach them, and finally how long you will need.
#3. Don’t just select the right asset class – merely equity is not enough – you need to select the right mutual fund and rebalance periodically.
#4. Know that no investment is absolutely safe, Bank FDs look safe but you lose money thanks to inflation and bank FDs may not return inflation beating returns.
#5. Buy insurance for unforeseen circumstances (if you have dependents).
#6. Take into account both long term and short term factors when investing.