All investments feature some nature of risk. However, we consider an investment as risky only if there is a possibility of losing the capital invested. But this absolute definition of an investment’s risk may be misleading, and even harmful, when used in making decisions about how to invest. You may be ignoring a wide gamut of risks to your financial security. It is important to recognise and understand the risks in different investments so that you can take steps to mitigate their impact on your finances.
Safe but losing value
The money held in products like the savings bank accounts is seen as secure and easily accessible. However, in return for this safety and convenience your money may earn lower returns. As the cost of goods and services rises over time, you will need more money to pay for the same things. But the money held in the savings bank account would not have grown at the rate required to keep pace with inflation. The impact of inflation on the value of money compounds with time. If you held the funds required to meet long-term goals in such low-return products, the erosion in value would mean that the money may be inadequate to meet your goals.
To earn the higher returns required to combat the effects of inflation, you should be willing to trade-off the safety and convenience to some extent.
Lock-in for higher returns
One way to earn better returns is to commit your funds for a definite period. Borrowers?such as banks, companies and government?are willing to pay a higher return for funds that are promised for a longer, fixed tenure. Deposits with banks, non-banking finance companies (NBFCs), post offices, and bonds issued by government and companies are examples of such products. The additional return that you earn is for giving up easy access to your money for this period. Assign only that portion of your savings, which you are sure you will not require for your use for the period of the investment. Most long-term fixed-term products may have a penalty for early withdrawal.
While the inflation-protected returns will safeguard the value of your money, there is still the risk that your savings may not be adequate to meet all your goals. Investing in products that give higher returns will mean that the contribution you need to make to the goal from your savings can be lower. It frees up savings to be used to meet other goals. But higher returns can only be earned when you are willing to take some risks on the principal invested and the expected returns from the investments.
Higher return, higher risk
Earn better returns by accepting volatility in your investments. The total returns that you earn from investments such as stocks, real estate, gold and even bonds will depend upon the change in the price of the investment. When the price appreciates, the total returns you earn goes up, and vice versa. If you make the right selection, monitor your investments, recognise the importance of staggering the investments and redemptions over a period of time to reduce the impact of the volatility, and rebalance the investments based on performance and your investment horizon, then such investments provide you the opportunity to earn higher returns.
Match investment to need:
Every investment choice, even the choice not to invest, brings with it certain risks to your financial security. It may be the risk of your money losing value, or it may be the risk of low returns that put your goals at risk or it may be the risk of volatility in the returns and losing value. The risks cannot be eliminated but their impact can be mitigated by matching each product to a financial need.
The safety and liquidity offered by a savings bank account or a money market mutual fund may be just the product to hold your funds to pay for a need that has to be funded in the immediate short-term. The impact of inflation is going to be negligible as the funds are going to be used soon.
There is no ?one size fits all’ allocation to the different product classes. Your portfolio of investments will reflect your need for liquidity, regular income and appreciation, the time to your goals and your preference for risk. Each investment should be assigned a defined role in your financial plan based on its return and risk features.
This will ensure that the risks are mitigated and they contribute efficiently to your financial goals.
**Source: MINT