Modules for Investors
More about risk and risk management
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Learning to say 'yes' to risk
In the previous chapter, we saw the concept of the risk pyramid and discussed how you can use the asset allocation strategy to construct an investment portfolio of your own. In this one, we’re going to look at why taking risks is important for wealth creation.
If you’re a very conservative investor who always shies away from risk altogether, then this chapter can help you get past your fears and allow you to learn to say ‘yes’ to risk. Now, without any further delay, let’s begin.
Why should you say yes to risk?
Risk is not something that’s inherently bad. In addition to this, it is something that you can’t fully avoid if you ever hope to create wealth. Yes, that’s right. Remember the previous chapter and how you should ideally invest a significant portion of your investment capital in ‘low-risk’ investment options? There’s a reason why these investment options are termed as ‘low-risk’ and not ‘no-risk.’ That’s because you can’t actually escape risk altogether, as evidenced in the last chapter of the previous module. And when you can’t escape it, why fight it instead of embracing it?
Confused? Here’s a good example.
Let’s say that you’re not overly fond of risk and so, you liquidate your stock market investments and reinvest the amount into government securities, since you feel that holding your investments in government bonds has absolutely zero risk. However, that’s not the case. Surprised? Yes, it is true. By holding your investment capital in G-secs, you’re still under risk; more specifically inflation risk. So to sum it up, by moving from stock markets to G-secs, you haven’t actually eliminated risk. Instead, you’ve just moved from one kind of risk to another.
This is precisely why you shouldn’t try to eliminate risk altogether. Instead, you can simply learn to embrace risk wholeheartedly. That said, when we say embrace, it doesn’t mean that you should be okay with whatever levels of risk an investment option comes with. You should still try to bring down the overall risk of your investment portfolio as much as possible through various strategies. This way, you would still be saying ‘yes’ to risk, while also doing your best to reduce its impact.
How to learn to say yes to risk?
Now that you know why you should say yes to risk, let’s take a look at the various ways in which you can learn to say yes to it.
1. Understand the difference between risk tolerance and risk capacity
The first and foremost step towards learning to say yes to risk involves understanding the difference between risk tolerance and risk capacity. While many investors use these two terms interchangeably, they actually stand for different things.
Risk tolerance is basically the amount of risk (or in the case of investments - losses), that you’re willing to put up with. Risk tolerance helps determine just how long you can hold on to your investments during a bearish downtrend without selling it. It also determines how much of a loss you’re willing to bear.
Risk capacity, on the other hand, is just how much risk you can afford to take financially. Risk tolerance is an emotional concept. Risk capacity, on the other hand, depends on your finances. Properly understanding what these two terms represent and the differences between the two can help you come to terms with risk.
2. Determine your risk tolerance and capacity
Once you’ve understood what the above two terms are, the next step is to go about determining your risk tolerance and risk capacity. You might consider yourself averse to risk, but this process can help open you up to risk by putting things in perspective.
Through this analysis, you can get to know the amount of impact risk and losses have on your life. If you find that minor to moderate losses don’t have that much of an impact on your lifestyle, you might be more inclined to say yes to risk.
The best way to determine your risk tolerance and risk capacity is to take a questionnaire. You can find many of them online - for free. Try to answer these questions truthfully. At the end of it, you will get a rough estimate of where you stand in terms of risk tolerance and capacity.
3. Calculate the risk-adjusted returns of investments
Upon analyzing your risk tolerance and capacity, the next logical step is to find out the risk-adjusted returns of various investment options. The risk-adjusted return essentially helps you understand how much risk is involved in generating a certain level of returns.
By adjusting the risk against the return, you essentially take the element of risk away. This makes the resulting figure a more accurate representation of the amount of return that you’re more likely to get if you invest in that particular option.
That’s not all. It can help put things in perspective as well. For instance, let’s say that you consider investing in a mutual fund a risky proposition. However, upon calculating the risk-adjusted returns of a particular mutual fund, you find that the returns are quite attractive in comparison with the risk taken. In such a situation, wouldn’t you be more likely to say yes to this risk?
4. Create a diversified portfolio
Once you’re done calculating the risk-adjusted returns of investment options, you should try to create a diversified portfolio with multiple asset classes added into the mix. This can help lower the risk even further. If you’re finding it difficult to construct a diversified portfolio, you could always turn to the risk pyramid allocation strategy for help. Make sure that you invest a significant portion of your money in low-risk options and the remaining in a mix of both moderate risk and high risk options.
By holding a mix of bonds, money market instruments, real estate, and stocks in your portfolio, you would not only be saying yes to risk, but would also effectively be reducing its impact on your portfolio. In addition to that, you would get to enjoy returns that are in line with your financial goals as well.
When it comes to investing, you can never completely stay away from risk. As a matter of fact, risk is an integral part of investing. All that you can do, however, is decide the kind and quantum of risk that you are willing to take and manage it effectively. If you want your financial goals to get fulfilled, then it is extremely crucial to say yes to risk.
A quick recap
- There’s a reason why these investment options are termed as ‘low-risk’ and not ‘no-risk.’ That’s because you can’t actually escape risk altogether.
- To embrace risk, it is important to understand the difference between risk tolerance and risk capacity.
- Then, determine your risk tolerance and capacity.
- The next step is to calculate the risk-adjusted returns on investments.
- Once that is done, make sure you create a diversified portfolio that matches your risk profile.