Understanding The Risk Factors

Last year when my son who was in standard XI, tried to negotiate a deal with me. His argument was, since the school bus charges Rs2,500 per month and the EMI of a new two-wheeler for two years was also the same, it is better that I buy him the two-wheeler because in addition to his convenience I will also own an asset at the end of the tenure. Though his logic was sound and convincing, but he did not consider the higher risk that would be incurred on a daily basis vis-à-vis a school bus. Likewise, I have heard my investors asking for the product with best return and least risk. Well, that product is yet to be designed.  What I mean by the above anecdote is that there is always a trade-off between risk and other factors, in the above case comfort and convenience or in case of investments, returns. What I want to highlight here is the all pervasive question – how much risk should I take or need to take while investing in mutual funds, now that there are many categories with various risk profiles across the mutual funds spectrum?

1. Identify your risk perception

Your understanding of risk may not be similar to mine. I may classify a 20 per cent loss of capital as risk I can live with, but you may lose your sleep over a 10 per cent loss.

2. Age profile and cash surplus

If you are investing for retirement, the greater the gap between your current age and retirement-age, the higher will be the compounding effect on investments. Similarly, the investable surplus of each month from your income will also determine your risk profile. You will be able to set aside a higher amount each month to deploy into investments.

3. Your target amount

If the goal amount is too large or more optimistic than your propensity to invest, then you may have to scale down your target amount or increase the investment amount. While it is always good to have optimistic targets, however, one also needs to be realistic about what can be spared for investments.

4. Understand the risk and reasons for selecting the particular risk level

Many times we are driven only by returns and do not understand that the return has come at a higher risk. That is when we need to ask ourselves if we really need to take that risk to achieve the result.

5. Consult your financial planner

Make sure your advisor understands what makes you uncomfortable and that while it is desirable to take risk for higher return, it may not be your temperament to take risks even at the cost of compromising on returns. The last thing you will like to do is to walk out of an investment plan as it affects you more than the advisor. Remember it is your money that he is managing!

6. Be familiar with certain risk measurements and their units of measurements

While I do not want you to be an expert in investment terminology but it will help you to understand what you are getting into if you understand a few terminologies like Standard Deviation, Beta and Alpha. Please ask your Financial Advisor to explain these terms to you. Always be aware of the risks inherent in the investment universe, be it fixed deposits or sectoral funds. I have attached a graph to highlight risks associated with various schemes.

Happy Investing!

The author is the wealth advisor and Founder, Tangerine Ideas