When it comes to investment, high risk is associated with high returns. In order to earn good returns with low risk, investors need to evaluate the performance of investment assets on a constant basis and reallocate funds whenever needed.
Their objective is to achieve a financial goal in an optimum time frame. To maintain an appropriate balance between risk and return, you need to protect your investments from several uncertainties.
Let’s look at five types of risks investors must watch out for.
This is a silent risk, and you don’t feel its presence on a constant basis. An investor mainly focuses on the ROI while investing, missing out on the impact of inflation on the investment in the long run. You must look at the real rate of return by considering the impact of inflation and tax implications on your investment. Let’s understand this with the help of an example.
Say, you have invested Rs. 1 lakh in a Mutual Fund scheme for five years and you expect the return to be 10% p.a. (normal rate, ‘NR’). The prevailing inflation rate (IR) is 7%.
A = P (1 + r/n) ^ nt (A=Corpus after a certain period; P= amount invested; r= interest rate; n = compounding frequency in a year; t= number of year)
So, in five years the corpus would be 100000 (1+.1/1) ^5= Rs. 161,051. The gains would be Rs. 61,000.
The real rate of return would be (RROR) = (1+NR) /(1+IR) -1= 2.804%= Rs. 14,828.
With inflation at 7%, the value of your corpus would be only Rs 1.148 lakh.
Inflation eats into a portion of your profit in five years, thus reducing the value of money. You must invest in assets which offer a return higher than the expected inflation rate during the period of investment.
Additional Reading: Drama Lama Learns About Inflation
Lack of Liquidity
You don’t want to lock away all your money into assets that have a long maturity period and do not allow interim withdrawals. You won’t have funds to survive emergencies. You will either end up borrowing from a friend or taking a loan which will cost you a higher rate of interest than your investment could offer. The ideal way to go about investing is by diversifying your money into multiple asset classes with different maturity periods. This would permit you to invest in instruments that allow liquidity, such as Fixed Deposits or liquid Mutual Funds.
Investment assets, especially the market-oriented ones, are prone to volatility and do not offer fixed or assured returns. They may follow the market trends, thus taking your returns either up or down, especially over a short period of time.
To mitigate your volatility risks, try to hold on to your investments over a longer tenure. A systematic investment plan (SIP) in Mutual Funds, for example, reduces your volatility risk, as the investment is done periodically and provides opportunities to average investment costs.
People often follow the herd when it comes to investment decisions. They must pause and examine the reliability of an investment option and whether it helps them achieve their money goals. Making financial decisions based on the wrong information can cost you a lot of money. So before you invest, you must analyse all pertinent information in depth. Don’t be shy of consulting a financial advisor, if necessary.
It is also known as currency risk and it is a threat when you invest in an instrument that is exposed to fluctuations in currency rates. For example, you had invested Rs. 1 lakh in an international fund at a time when the exchange rate for one USD was Rs. 68. So, you had invested $1470.58. In a year’s time, your investment grew by 5% to $1544.11, but at that time the Rupee appreciated against the USD to Rs. 64. So, on redemption you would get 64x$1544.11, i.e. Rs. 98,823.04. You have effectively made a loss of Rs. 1177 after investing for one year. Use appropriate hedging tools to mitigate the impact of currency risk.
The best way to mitigate these risks is to diversify your investment adequately and evaluate the portfolio from time to time. Also, do not make hasty money decisions.
(The writer is CEO, BankBazaar.com)