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.