Let me start with a story.
A few days back, I was travelling to work by train.
Two middle aged men were sitting opposite to me.
Like me, they were travelling to their office place as well.
I was attracted to their conversation. They were talking about the demonetisation issue.
It seemed, they were both pleased with the Indian Government.
"We are having some troubles, but it'll benefit us in the long run." - one of them said. Most of the people around them also agreed to this. He was encouraged by the general reaction!
"This is why I never take investment risks. I don't need to be rich. I want my money safe."-he continued.
"Not only money, in daily life too, I try to avoid risk as much as I can. I may reach late at home. But I don't board at moving trains or poke my nose in other's stuff. Nowadays, it's better to keep your head down......"
Slowly, the discussion turned to how bad this world has become. They mentioned pollution, terrorism, adulteration, diseases etc.
Meanwhile, I reached my destination. I got down from the train. Those two gentlemen were behind me.
They followed me to the bus stop. While we were waiting, both of them pulled out cigarettes from their pockets and began to smoke.
I called out to them- "Excuse me sirs! If you don't want to take any risk, then why are you smoking?"
They were startled at first!
Then they understood what I had said. "Sorry madam!" - they dropped the cigarettes.
I don't know whether they'd give up smoking for good or not. But I was left wondering how the common man sees the concept of risk.
What I think is - the concept of risk differs widely from man to man.
What is normal to you may be risky for someone else. And you cant avoid risk. You must learn to manage it in life.
You can't avoid risk. You must learn to manage it. - Marbias Money.
Same principle applies to money also. Some of you may think business is risky.While others earn huge income from business.
Some of you may think Bank Deposits are the safest investments. While someone else may think Liquid Funds are even safer than them.
The bottom line is...
You must learn about all the risks to your investments. So that you can manage them yourself.
And today, I want to show you how you can do that.
Are you ready?
What is Investment Risk?
Investopedia defines the term Risk as below-
Simply speaking, risk means the chance that you may not get the return that you expect from your investments.
You may get less than you expected. Or, in the worst case, you may not get back even your principal amount!
If you are like the typical Aam Indian, your first priority is that your principal amount remains safe and secured. After that you expect a good enough return on your money.
The expected return may differ from person to person. Some are satisfied with 8-10 %. Some want it to be 12% and above.
But security of the principal is the most important factor. Let us call it the safety first approach to investing.
Safety first approach is good. But it has it's downsides also. For example-
- You don't learn about other investing options.
- You may lose much of your money to inflation.
- You miss better tax saving opportunities etc.
Tell me one thing,
Did you stop learning to ride a motorbike because it was risky?
You fell down, hurt yourself. You might have injured others too. But you did not stop learning.
You learnt to ride a motorbike because you enjoyed it. You took the risk of falling down. And you overcame it. Because it was fun.
It is the same thing with your money. If is necessary for you to know about all the risks.
When you know what the risks are before putting your money in. You can be sure that your money is safe and secured.
Types of Investment Risks
#1. Investment Risks related to Cheats, Frauds and Mis-selling
This is the biggest risk in India. Because here people have very little financial knowledge.
Frauds and unethical sales people regularly take advantage of it to create havoc in India. They sell ponzi schemes, chit funds, wrong insurance policies etc. to customers who trust them.
When the customer finds out the fraud, it's already too late. He is neck deep in trouble.
The solution is financial education!
You can identify a fraud only if you have the knowledge to catch his lies. I want to provide you with this knowledge. Read the articles on this website to learn everything you need.
#2. Investment Risks Related to Inflation
Inflation is the silent thief of your money.
Former US president Ronald Reagan famously said -
Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.
Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man -Ronald Reagan.
Let me show you an example,
Imagine that you get a salary of ₹25000/- now. And your monthly expenses are ⌑23000/- . So, you save ₹2000/- every month after all the expenses.
Suddenly your boss declares today that he will never increase your salary again. That means, from now on , you'll have to cover your expenses from this ₹25000/-
You can do it if the prices of all the goods remain the same also. But, here is the problem.
Prices of goods, generally, don't remain fixed. They keep on increasing or decreasing slowly. When they increase, it is called inflation.
In India, the average rate of inflation is 6-7%. So, goods that cost ₹100/- now will cost ₹106/- after one year.
Similarly, what you buy with ₹23000/- for your family will cost you ₹24380/- next year. ( If you want to see the calculation, let me know by commenting below.)
Next year, it will cost you ₹25843/-. What about after 10 years?
At this rate, after 10 years you'll need ₹41189/- per month to run your family. That's almost 180% of your current monthly expenses.
This is way more than your salary. You'll no longer be able to support your family from your salary. You'll have to look for additional income.
If you can't increase your income, you'll get poorer and poorer every day.
Inflation sucks away your money like a leech sucks you blood. You must always try to control it.
How can you contain inflation risk?
There are two ways-
- Always actively try to generate additional sources of income.
- Invest at least 50% of your money in products that give inflation beating returns in the long term. For example- Equity Mutual Funds, Shares of good companies etc.
#3. Investment Risks related to Interest Rate fluctuation
Interest rate risk is applicable if you invest in bonds.
The price of bonds in the market varies inversely with the interest rate in the market.
- The price of bonds goes up when interest rate goes down.
- The price of bonds goes down when interest rate goes up.
If you invest in bonds or debt mutual funds, then interest rate is one of the main investment risks for you.
- Keep an eye on interest rate movement before investing in bonds.
- It is better to invest in debt mutual funds. Because then the fund manager is responsible for taking decisions related to interest rate risk on your behalf.
#4. Investment Risks related to Default in repayments
It means that someone who has borrowed money from you, does not return it with interest.
Default risk is also known as credit risk. If you give loans to individuals or companies, you suffer from default risk.
You can give loans to companies by buying their Bonds and Fixed Deposits. Company bonds or fixed deposits usually provide more interest than Bank Fixed Deposits.
While more interest will help you beat inflation easily, but the default risk is high in these investments. You must select the borrower cautiously before investing your money.
- Always invest in Company FDs or Bonds that has a high credit rating. CRISIL , ICRA give rating like AAA, LAAA etc.to these bonds. These ratings depend on the company's ability to return your money.
- Keep periodic watch over these ratings. The credit rating agencies may change these ratings if the company suffers any big loss. If you see that the ratings has dropped, you may sell your bonds and take out your money.
- If you want to invest via P2P lending platforms, select the borrower carefully. Verify his profile to make an assumption about his paying capabilities.
- Don't lend all your money to a single borrower. If you have 100000/- to invest, divide it in 4 parts of 25000/- each and lend to 4 borrowers. This is called diversification.
- Don't lend for very long term. Maximum term of 12-18 months is safer.
#5. Investment Risks related to Liquidity
Liquidity means the ease of getting your money back.
When you invest your money, you will want that you get your money back when you want. But you can not sell every investment easily.
For example, Bank FDs are more liquid than physical gold. You can break Bank FDs when you want. You may have to pay a small penalty in you break it before maturity. But you can not easily sell physical gold that easily.
On the other hand Liquid Mutual Funds are even easier than Bank FDs. You take out your money any day. Moreover they won't charge you any penalty for it.
Other highly non-liquid assets are - Real estate, Arts and Crafts etc.
Don't invest all your money in non-liquid assets. If you need large cash suddenly, you'll be in trouble.
Distribute your investments between more liquid and less liquid products.
- For the cash that you may need immediately use cash at hand, savings account and liquid mutual funds.
- If you need money with 3-4 days to 1 week use Bank FDs, Debt Mutual Funds, NPS Scheme Tier II account etc.
- Don't invest money that you may need to withdraw suddenly in shares or equity mutual funds.
#6. Investment Risks related to Re-investment of maturity value
Let me explain re-investment risk with an example-
Imagine you have retired 2 years back. You don't get any pension. After retirement you invested everything in Post Office MIS at 9.25 % per year.
You get a monthly income of 30000/- from your MIS. Currently it is enough for your needs.
But, you have already completed 2 years from the MIS maturity term of 5 years.The interest rate in Post Office MIS has dropped from 9.25% to 7.80% at present .
In another 3 years this MIS will mature. You will have to reinvest in a new MIS scheme then. Will you get the 9.25% interest then?
If you don't, you'll have to invest at a lower interest. Your monthly income will decrease as well. Will you be able to maintain your family then?
This is an example of re-investment risk.Please note that this risk arises if the interest rates go down. Like it is doing now.
If the interest rates go up, then this risk vanishes. This risk is valid for all fixed income products like- MIS, Senior Citizens Savings Scheme,Fixed Deposit, Bonds etc.
- Keep an eye open for which way the interest rate may go. A good indicator in inflation. If inflation is rising, chances are that interest rates will go up as well.
- Don't invest your money at one shot. Stagger it in parts. This way you can delay the maturity over a longer period.
- When interest rate is going down, invest all your money at one go to lock into higher rates.
#7. Investment Risks related to underlying business
This risk is applicable for equity investors.
If you invest in equity, you buy shares of a company. Business risk is related to the operations of that company.
For example, a companies performance depends on factors such as employee expenses, raw material costs, competition etc. Any adverse situation in these factors can affect the performance of the company.
- Build a portfolio of equity shares of companies from different sectors. It will help you to overcome business risk for a particular business sector.
#8. Investment Risks related to Exchange Rate fluctuation
Exchange rate risk occurs when the value of Indian Rupee goes up or down against against a foreign currency. Like, the US Dollar.
It is one of the major investment risks for the NRIs and export/import oriented companies.
The NRIs often repatriate their money to India. If the value of INR goes down against USD, then the NRIs lose a big chunk of their money.
If you have investments abroad, you too are vulnerable to exchange rate related investment risks.
- There is not much that an individual can do to manage this risk. Hedging this risk by Forex trading is more suitable for businesses.
- For businesses, one solution is to hedge this investment risk by buying Forex options or futures.
#9. Investment Risks related to the general Market
Market risk means the risk of adverse developments for the whole asset class.
Suppose you have got 1000 shares of Indian Oil Corporation (IOCL).
Since IOCL refines and markets oil in India, it is highly dependent on the price of crude oil in international markets.
Lets say the price of Brent crude goes up. Then the cost of input goes up for IOCL. As a result it's profits goes down.
The opposite happens if the price of crude oil goes down
This is an example of market risk.
- Diversify your portfolio among various sectors to manage this investment risk.
- Also hold different asset classes like - stocks,bonds,gold,real estate etc. to manage market risk related to an asset class.
How to balance Risk with Return
My recommendation is simple-
- Check all your investments. Find out which of these investment risks apply to each of them.
- Try to minimise the risk by applying the solutions mentioned above.
- If you can't apply any solution to any investment, keep it under watch. Then sell it when you make a profit.
- Then re-invest this money to some other asset where you can manage the risk.
Today you learnt about all the common types of investment risks.
Apply this knowledge in your life. Find out about the types of risks in your own investments. In next article you shall do some practical work. 🙂
Actually, I shall show you how to use Excel to determine the risk level of an investment.
Before I finish today, just one request...
If you liked this article, please let me know by commenting below and share this article with your friends.