Be it stocks, mutual funds, bonds, exchange-traded funds or real estate, there is an element of risk in all types of investment.
The only thing that separates them is the degree of risk.
In order to understand this better, let’s look at factors such as investment risk management, investment risk and return etc., amongst others that determine the risk level of each investment option.
Factors that influence risk element of each asset
What is investment risk? The risk level of each asset is dependent on its characteristics, investment horizon and behaviour (the way an asset reacts to change in overall market, political and economic environment, interest rates etc.).
• Level of volatility
Volatility indicates how rapidly the value of an investment asset can change in a specific time period.
This is why stocks are considered volatile. That’s because share prices can change several times in a short time. This means that you can either make a large profit or lose a large chunk of your investment in a short time. A fixed deposit, on the other hand, is less volatile because its value doesn’t change intermittently. This is why fixed deposit returns you receive are fixed.
• Time horizon
Duration of an investment can determine the risk level as well. For example, a short-term equity investment can be risky because its value changes constantly. But when it’s held for a longer period of time, various studies show that equity is a high-performing asset class. That’s because the price of equity usually flattens in the long run. There is a sense of stability in the long run.
Meanwhile, debt investments are relatively safe for short- to medium-term goals. That’s because they provide steady returns if not kept for very long. They can be a long-term investment option as well but the returns may not be able to beat inflation. This is why people usually opt for equity over the long-term and debt investment for a shorter time period.
• Nature and characteristics
You also need to look at the nature of an asset class (equity, debt and gold are some examples of an asset class). Let’s take the example of stocks again. Owning shares of a company means you own a part of their business. You are entitled to company’s profit. You are also expected to bear the loss. This is why stock investments can be a high-risk, high-reward investment.
On the other hand, investing in bond means lending money to an entity (it can be a government or a corporate) for a defined period. The chances of losing your money in such cases occur only if the company or the government default.
• Asset behaviour towards economy
Risk can also be assessed by particular asset’s behaviour towards prevailing economy. For example, market value of bonds reduce with an increase in interest rate and vice versa.
Equity investments also get impacted by everyday price movement, industry performance and many other factors.
• Individual investor’s risk tolerance
In the end, everything boils down to an investors’ ability to take risk. For example, investing in equity can be a risky proposition for a retired person because they usually look at an asset class that can provide them a steady source of income. In contrast, the risk appetite of a younger person is usually higher and may opt for equity. That’s because they can absorb the short-term volatility and wait for the investment to potentially provide high returns in the long run.
To sum up
Every financial asset has a degree of risk. Understanding the nature and level of risk helps you manage those risks effectively to pursue your financial goals. This is why IndiaNivesh can offer you specialised solutions to achieve your financial goals.
You might not be born rich but you can grow into wealth. After all, becoming rich is not luck. It is effective financial planning. And to make an effective financial plan, you need to employ a few basic financial planning tips and avoid mistakes that can jeopardise your entire financial plan.There are some best financial planning tips which, when followed, lead to effective financial planning. Do you know these financial planning tips India? They are simple to follow and can easily manage your debt. Here are some:• Save first, spend laterThis is the first tip for you to follow in your financial planning process. Whenever your income is credited, save a portion of it first. At least 30% of your income should be directed towards savings for your financial goals. Of this 30%, hold 10% in an emergency fund for unforeseen expenses. (Link to thumb rule article). Also, another 10% should go towards a retirement corpus. This way, you start retirement planning early and retire rich. • Plan your taxes and tax savingTax is an integral part of your income. Breaking it into relevant sections like medical, travel, etc. can be a nice trick. It can help you make the most of all possible tax exemptions and deductions. Here are some tips to maximise tax benefits:• Section 80C lets you save up to Rs.2 lakh of your taxable income from tax. Use the investment avenues of this section to maximize tax-saving. You can choose from PPF, ELSS, 5-year Fixed Deposits, National Savings Certificates, etc. This includes the additional Rs.50,000 deduction that you can get through National Pension Scheme (NPS). • Section 80D lists tax-saving options on health insurance for self, spouse children and dependent parents. You can save up to Rs.60, 000 of your taxable income if you pay premiums for health insurance policies of your family and your parents. Also make use of the tax deductions on medical expenses. • Home loans can save tax in two ways. You may know about the deduction on principal repayment as a part of 80C. But do you know that the interest component also gets a tax deduction, over and above the limit of Section 80C? This is as per Section 24 that allows interest on home loan to get you a tax deduction. This section’s provisions can be utilised for maximum tax-saving.• Manage your debts: Control bad loans, optimise good loansThe next important tip is managing your debt. Repay your loan instalments on time to avoid damaging your credit score and high interest payments. Stay away from or get rid of bad loans and optimise good loans. Here are some ways how: Bad Loans:1. Credit card loans involve very high interest. Also, the interest is charged on a per day basis until you pay off the debt. Thus, the interest compounds and your net cost rises too high. So, pay off your credit card loans first. Never revolve credit card outstandings.2. Personal loans also have high rate of interest and little tax efficiency. After you pay your costly credit card debt, prepay or pay off your personal loan debt next. Refinance loans to lower interest rates if possible too. 3. Car loans being secured loans have a lower rate of interest. But they can be paid off at the earliest too. After all, they provide no tax relief, unless you are classified as a ‘professional’ in the tax system. Good Loans:1. Home loans are good loans as they help you save tax. We read earlier about the tax deductions on your home loan principal and interest repayments. So, if you have a home loan, don’t rush to prepay it.2. Similarly, zero-interest finance options need not be prepaid. Instead, use your excess funds for investment to generate good returns.3. Education loans too provide tax benefits. So, think twice before prepaying these too. • Don’t put all eggs in one basket: Diversify your investmentsDon’t favour one investment avenue. Diversify. Have a good equity-debt mix in your portfolio. The proportion of debt investment in your portfolio should be equal to your age. As you grow older, your debt investments can increase as your risk-taking ability reduces with age. Of course, don’t confuse this with loans and other debt liabilities. Equity allocation should depend on your risk appetite.• Pen your goalsGoals are best understood and remembered only when they are penned down. Analyse whether your goals are short-term or long-term ones. At least 10% of your investments should be directed towards long-term goals, while the rest can be directed for short-term investments. Pick the right investment avenues based on the horizon of your goals. Don’t invest in long-term investments for your short-term goals.
Risks are a constant in the world of investment. They cannot be eliminated. But, there are strategies to minimise them. How to reduce investment risk? Investment risk can be reduced by risk mitigation strategies to ensure that the end goal is not adversely affected. How to manage investment risk? Risk management can be adequately managed through a fundamental component of in investment approach. It is needed to improve investment outcomes. The right strategy keeps losses within an acceptable boundary during hard times and helps to cover up losses during good times. Diversification is one such time-tested risk mitigation strategy. Here are some tips to diversify investment risk. What is diversification?Diversification is a means of managing an investment portfolio. Through this one can invest in a wide range of financial assets. So, even if a certain set of your assets do not perform well, it can outweigh the declining performance of the rest of your portfolio. Diversifying balances out and reduces the overall risk associated with a portfolio. Every asset performs differently based on the prevailing market conditions. Diversification is all about investing in various non-related assets to balance out the risk exposure. Non-related assets are assets like equity, bond and gold, whose performance does not depend on each other.Some assets are also co-related to each other’s performance. For example, equity markets tend to slump during an economic downturn. During such times, the Reserve Bank of India (RBI) tries to stimulate economic growth by lowering interest rates. As interest rates start to fluctuate, co-related assets such as bond prices also tend to go up and down. Thus, equity and debt are inversely correlated to some extent. In short, diversification simply refers to ’don’t put all your eggs in one basket’. Instead of investing in a single investment avenue, you can invest in multiple financial assets such as stocks, bonds, mutual funds and real estate etc. Moreover, you can also choose to diverse the investments within the same asset class. For example, you can invest Rs. 10 in different shares of varied sizes, industries and sectors. In doing so, you are at a minimal risk of loss in the event of a fickle market environment.Thus, a well-diversified portfolio helps you in the long run by spreading out the risk of an asset and minimising overall investment risk, thus helping you to pursue your investment objective. Here it is important to note that though diversification effectively reduces overall risk, it cannot completely erase it. *The table suggests that the average risk of the portfolio reduces with the rise in the portfolio size.How to diversify investment risk? Spread your investments across different assets. The risk and return profile of each asset class could vary. Equities are riskier than bonds. Hence, choosing a proper mix of less, moderate and high risk investment avenues can also help in diversifying as per your risk profile and time frame to achieve investment objective. Every asset class responds differently to economic changes. Therefore, figuring out the right mix based on your investment plan is the key to diversification. Consider different assets within the same asset category. To build a diversified equity portfolio, buy 15-20 stocks across varied sectors. Opt for negatively correlated stocks. For example, you can choose to invest in shell stock (oil production companies) and airlines (oil consumer) as the price of these company shares are negatively correlated. Negatively correlated stocks perform better if the other one drops, i.e. contra performance. Thus, diversification helps in averaging out the returns so that if one asset class does not perform well in a timeframe, the other one would make up for it. Remember diversification is an ongoing process. You need to constantly review your portfolio and rework on your diversification strategy based on your current need and situation. A disciplined approach can help you survive the ups and downs of a volatile market. Take expert help. Seeking help of financial experts can help you in building a well-diversified portfolio. Financial experts can help in designing a diversification strategy that can effectively reduce risks and maximize your potential returns in the long run. ConclusionIn a nutshell, diversifying your investment among various asset classes protects you against significant losses by mitigating risks. Follow an asset allocation strategy as per your risk tolerance, investment goals and financial circumstances. Diversify among and within various asset classes to reduce risks and achieve your financial goals. Get guidance from a financial professional on asset allocation and diversification for your portfolio. IndiaNivesh expertise in the field can help you mitigate the risk through diversification to achieve your financial goals.
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