Risk Management in Investing

“The market can stay irrational longer than you can stay solvent.” – John Maynard Keynes

Where you should invest is completely dependent on who you are, what type of risk you can take and how long you can keep your money invested. Imagine someone who wants to remain risk free and decides to invest everything in bank fixed deposits. If we assume inflation at 6% and returns on fixed deposits to be 6.5%, then income tax at 30% reduces the real return from 0.5% to (-)1.4%. In this scenario, it would have been wiser to spend the money rather than investing it.

Not taking risks is the biggest risk in itself. Keeping all your money in a low-interest savings account to avoid investment risks. Inflation could erode the purchasing power of your money over time, hindering your ability to reach financial goals. As Lord Tennyson has beautifully expressed “It’s better to have loved and lost than never to have love at all.”

What is Risk?

In the world of investing, risk refers to the possibility that your investment will lose value, or that you won’t earn the return you were hoping for. It’s the uncertainty associated with the outcome of your investment decisions. Risk is the manifestation of uncertainty. Risk is dynamic. It can take away or create fortunes. Risk cannot be eliminated, it has to be managed.

Not taking charge of our money can be one of the biggest mistakes we can make in life. This can result in many setbacks and compromises in our life.

Types of Investment Risk

Market Risk

This is the overall volatility of the market. It means that your investments will fluctuate in value. For example, the market value of stocks and mutual funds keeps on changing throughout the day.

Inflation Risk

Over time, inflation erodes the purchasing power of your money. Investments that don’t keep pace with inflation can reduce your returns. These investments can be risky for long-term goals.

Liquidity Risk

This is the risk of not being able to easily sell your investment and access your money when you need it. Some investments, like real estate, might be harder to sell quickly compared to stocks.

Opportunity Cost

This refers to the potential benefit you give up by choosing one investment over another. In simpler terms, it’s the “what if” scenario.

Let’s say you invest in a low-risk savings account with a guaranteed 1% annual return. While this is a safe option, you might miss out on the chance for potentially higher returns by investing in stocks, which historically have offered higher average returns than savings accounts, but also carry more risk.

There will always be some level of opportunity cost involved in any investment decision. There is no way to completely eliminate it. However, by

Clearly defining your investment goals and risk tolerance.
Conducting thorough research on potential investments.
Developing a diversified investment strategy.

You can increase your chances of making informed decisions and potentially minimize the impact of opportunity cost in the long run.

Duplication Risk

This refers to the risk of unintentionally holding the same investment across multiple places in your portfolio. This can happen in a few ways:

Owning the same stock directly and also owning a mutual fund that holds that same stock. This means you’re essentially doubling down on that particular company’s performance, which can magnify both gains and losses.
If you invest in several mutual funds or ETFs that focus on the same asset class (e.g., large-cap stocks), you’re essentially replicating your exposure.

Consequences of Duplication Risk

Reduced Diversification: Duplication limits the spread of your investments across different asset classes, making your portfolio more susceptible to losses if a particular sector performs poorly.

Higher Fees: You might end up paying unnecessary fees for managing overlapping investments across multiple accounts.

To minimise duplication across your portfolio, carefully review your investment holdings across all accounts. Understand the composition of mutual funds and ETFs you invest in. You may use online portfolio tracking tools to identify overlaps or seek professional guidance if needed to ensure a well-diversified portfolio.

Reinvestment Risk

This refers to the risk that when you sell your investments, you might not be able to reinvest them at the same rate of return you earned previously. For example, selling a profitable and reinvesting the proceeds in another stock may not generate the same returns as the earlier stock.

Mitigating Reinvestment Risk

Invest for the long term: Focus on a long-term investment horizon to ride out market fluctuations and potentially benefit from compounding even with some reinvestment risk.

Diversify your asset allocation: Investing in a mix of asset classes can help mitigate the impact of declining interest rates in one area by potentially offering growth in others.

Types of Investors

Conservative Investor

These investors prioritize capital preservation and minimize risk. They are most comfortable with investments that offer lower potential returns but also lower risk of loss such as bonds and money market instruments.

This risk tolerance is suitable for investors with a short time horizon (less than 3 years) saving for near-term goals or those nearing retirement who want to protect their principal.

Moderate Investor

Moderate investors are comfortable with some risk in exchange for the potential for higher returns. They might allocate their portfolio across a mix of asset classes, including stocks, bonds, and potentially some alternative investments. They can handle some market fluctuations without undue stress.

This risk tolerance is suitable for investors with a medium time horizon (3-10 years) saving for goals like a down payment on a house or a child’s education.

Aggressive Investors

Aggressive investors are most comfortable with taking on significant risk for the chance of outstanding returns. They might invest heavily in stocks, especially growth stocks with high growth potential but also higher volatility. They are less troubled by market ups and downs and have a long time horizon (10+ years) to potentially ride out market fluctuations.

This risk tolerance is suitable for young investors with a long time horizon who are comfortable with potentially large swings in their portfolio value.

Risk Tolerance

FInancial Markets are fundamentally volatile. Price of financial assets keeps on fluctuating on a daily basis. Risk tolerance, in simple terms, is your ability to handle the possibility of losing money on your investments. It’s a measure of how comfortable you are with the ups and downs that come with investing. It also means how easily you can sleep in the night even if market value of your investments are temporarily down.

Risk Tolerance Factors

Following factors determine your risk tolerance.

Age: Younger investors generally have a longer time horizon and can tolerate more risk. As you approach retirement, you might become more risk-averse and prioritize capital preservation.

Financial Goals: The purpose of your investment will influence your risk tolerance. Short-term goals might require more conservative investments, while long-term goals can allow for more risk.

Financial Situation: Your overall financial security can impact your risk tolerance. If you have a significant emergency fund and other sources of income, you might be more comfortable taking more investment risk.

Final Thoughts

What we need to understand is risk tolerance is not static. It should be flexible and change as your life circumstances and financial goals change. Different levels of risk tolerance is required to achieve Capital Appreciation and Capital Protection. Regularly reassessing your risk tolerance and fine tuning is crucial to ensure your investment strategy remains aligned with your financial goals. The probability of investors’ capital lasting longer increases with superior risk to return investments and moderate volatility.

Risk management isn’t about avoiding risk altogether; it’s about understanding the potential pitfalls and taking calculated steps to mitigate them. By implementing a sound risk management strategy, you can invest with greater confidence, navigate market fluctuations more effectively, and stay on track to achieve your long-term financial goals. Remember, risk management is an ongoing process. Regularly review your portfolio, assess your risk tolerance, and adapt your strategy as your circumstances and market conditions evolve. By staying informed and proactive, you can empower yourself to make informed investment decisions and build a secure financial future.