What is the risk involved in investing?

RISK.

In simple terms, risk is the probability of loss. Your knowledge in investing is never complete until you learn about risk and it’s relation with returns.

When we talk from the angle of an investor, risk is the combined effect of –

  • Probable Loss of money invested.
  • The estimated loss of interest, should the money be invested in secured deposits.
  • Inflation that reduces your money’s worth.

When you invest, deviations can happen from the expected outcome. That deviation can be positive or negative. If deviation happens to the positive side, that would be considered as windfall gains. The negative part is called risk. Risk is part and parcel of every investment. Every type of investment involves risk of varying degrees, which can be very low in the case of government bonds to high as in the case of stocks.

We talk from the angle of an investment, different invest assets have different degree of risk. For example – government bonds are considered to be the least risky asset and logically, have the lowest potential return. Equities are considered to be highly risky and have the potential to gie you very high returns.

RELATION BETWEEN RISK AND RETURN.

The above example also brings to light the relation between risk and return. If you target for a high return, there is an equal possibility of a high loss.  So, Higher the risk; higher the returns. What we mean to say is that risk and returns are directly related.

RISK TOLERANCE CAPACITY

Tolerance means ‘easiness’ or ‘acceptance’. I simple words, it’s your capacity to sleep peacefully when the market is falling!! Risk tolerance capacity is our ability to accept or to live with a potential risk. Risk tolerance capacity would be different for different investors. It could also vary according to one’s knowledge about investing, his emotional balance, his age and life stage , his sources of finance, marital status, number of dependents etc..  Your views about risk will keep changing with variations in these factors.

So one point we would like to say here is that, before you invest in any asset, you should have a clear idea about –

  • The risk such an  investment carries and
  • Your risk bearing capacity ( which should match with the risk of the investment)

For example – You are interested to invest in stocks. After a self evaluation, you realise that you can afford to loose only 5% of your invested fund. Naturally, a proposal from your investment advisor to invest in a stock that may move 10% in either direction will not suit your preferences. That’s because, if risk works out, your loss would be 10% of the amount invested. Alternatively how about an investment call that has the possibility to give you 5% either way? You may accept. Because, if you gain, you get 5% but if you lose, you lose only 5% which is ok with you.

CATEGORIES OF INVESTORS BASED ON RISK

Now, depending upon how well you’ll adapt to risk, you’ll either be a conservative investor or a moderate investor or an aggressive investor. Conservative investors should not invest more than 20% of their money in high risk investments like stocks. Bonds and fixed deposits will be more comfortable for them. Aggressive investors can invest 90 or even 100% of their money in high risk investments like stocks. Moderate investors should try to strike a balance in between. Asset allocation and diversification becomes more relevant for moderate risk takers. That’s because, the risk averse would concentrate more on debt funds and hence they need not think about risk tolerance anyway. The aggressive would put major chunk of their money in stocks and have high capacity to tolerate risk. Hence, it’s the moderate risk takers who will be caught in the middle. For them , it’s necessary to create a  balanced combination of high risk, moderate risk and low risk investments.

THE REAL RISK.

Sometimes, in order to achieve your financial goals, you may have to take a risk which may be higher or lower than your tolerance capacity. That risk which you should actually bear is called the real risk. For example – you have just 4 years to invest but you are targeting a return of 200%. To achieve this you may have to take a risk that may be higher than your risk tolerance capacity.

MATCHING YOUR RISK.

Your risk tolerance capacity and the real risk should match in order to take effective investment decisions. This may be a confusing process. If you are not sure about how to do this, a financial advisor should be able to help you out.

CONCLUSION.

Investors jump head on to buy investment with great potential for returns without assessing their risk tolerance capacity and the real risk. It’s easy for such investors to get burnt in the process. The rule is simple, and you have heard it many times before- The higher the returns, the greater the risk. The lower the risk, the lower the returns.

We will take up the topic of ‘optimum risk’ and allocating assets accordingly in a different chapter. Right now, at this beginning stage, it’s enough for you to understand that there are two types of risk – one from the investor’s angle and the other from the investment’s angle.

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What are the stages in investment process?

There are 4 stages –

  1. Investment style / policy
  2. Investment analysis
  3. Valuation process
  4. Right mix of investments

INVESTMENT STYLE / POLICY

This stage involves taking decisions. It involves finding answers to the following questions.

  • What’s the risk you’re willing to take? Risk and returns are closely related. The more risk you’re willing to take, the more returns you’d expect. Where do you stand – are you a moderate risk taker or a heavy gambler? Or are you a really risk averse person?
  • How much money can you set aside to invest?
  • With the money you have, what are the assets in which you can invest?
  • How much time can you wait for your investments to grow?
  • What are your financial objectives? Do you think that you will be able to achieve your objectives with the money you have decided to invest? If yes, have you arrived at that decision by calculating the returns at a reasonable rate?
  • If your answer to the above question is ‘no’, how would you strike a balance? Will you bring down your financial goals by cutting off certain goals or would you try to increase your investable fund?
  • If you decide to invest in different assets like shares, real estate, gold etc.. How much are you willing to allocate to each type of assets and why?
  • Would you like your investments to be actively managed? That is, would you like to utilize the services of investments experts who would do their best to extract maximum gains for you using their expertise and experience? Are you willing to pay for their services?
  • If you’ve decided to take the stock market route, would you adopt a growth investment strategy or a value investing strategy? Or would you try to strike a balance in between ? Whatever may be the style you adopt , would you prefer to invest in a mix  large caps , mid caps and small caps or would you like to stick with one category?

Finding answers to the above questions would reveal your preferred investment style.

INVESTMENT ANALYSIS

A Comparative analysis of your chosen mix of investments. This would help you to decide whether the mix is optimal to achieve your goals.

  • At the base level it includes the analysis of your chosen investment asset – equity, debentures, bonds, commodities, real estate etc..
  • Broader level analysis would include analysis of the economy and industry, qualitative and historical analysis.

INVESTMENT VALUATION

This is the most important part of investment. Valuation is the process of estimating what the assets is actually worth. Valuation can be done for all assets. It is an attempt to determine the ‘reasonable price’ at which an asset can be bought so that it increases in value over a period of time. It is quite different from the ‘market price’ which is what a willing and able buyer is prepared to pay.

For example – if a builder offers an apartment for 65 lakhs, would you blindly buy it without analysing the builder’s track record and the facilities offered? Won’t you try to find out why he charges 65 lakhs for that apartment? Finally you would buy that apartment only if you find it attractive at that price. It is an individual decision after considering all the factors.

The same process needs to be done in any form of investment – whether it’s shares or mutual funds or commodities. You have to make sure that the asset you get is worth the money you spend.

RIGHT MIX OF INVESTMENTS

Putting all the eggs in one basket is not a good idea. There are some people who think that putting it all in one is better since they can concentrate on it and escape from the trouble of carrying multiple baskets at the same time. That’s a very wrong approach in investments and it needs to be corrected.

For example – if you put your money in real estate alone, should the real estate prices crash- as we saw 3 years back, you’re locked up with no other options. Instead, if you had your money diversified in stocks, gold, real estate etc you’d be better off since when your money goes down  in some, you gain in another and thereby reduce the risk of losing all your money.

Deciding the right mix is technically called ‘portfolio’ and managing it to achieve maximum results- in terms of risk reduction, capital preservation and returns is called ‘portfolio management’.

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What care should one take while investing?

Before deciding about any investment, there are a lot of things one should be careful about. This includes:

COPIES OF DOCUMENTS

Any investment scheme will have a written document which explains the offer. It’s important that you ask for those documents and keep it in a file with you. Investment advisors and sales person work on a target basis and they work under lot of pressure from the management. Obviously, these people would explain details in a way that the scheme is attractive to you. It’s part of their duty to present it well and attract customers. They are trained to do that.  Many of those offers may be subject to lot of terms and conditions. Finally, when you find a mismatch with what was said by the sales person and what’s happening the investment scheme, the company will ask for written proofs!!

So always insist on obtaining a copy of any document you sign.

READ, UNDERSTAND AND THEN SIGN IT.

Some people do collect all the information in written form, but they fail to read the lines carefully. In any investment broacher or document, the negative factors or unfavorable terms and conditions will be written in the smallest of letters possible!!

VERIFY THE LEGITIMACY

Investment scams have become very common these days. People invest in schemes that are received through email or phone calls or representatives who lure them to invest in a product or property or forex. Before investing consult a financial advisor or an advocate and verify if the legitimacy of the company that’s promoting the scheme and also if such schemes are allowed to be operated. Also note -

  • The licenses or permit granted and the Act or Law under which the scheme is allowed to operate.
  • The truthfulness of testimonials and references they present.
  • Details of head office, branch offices etc. If possible try to visit the office. Most fraud schemes are very confident about the results but fall short when it comes to details.
  • Remember that existence of Websites and phone numbers are not proofs for the legitimate existence of a company or scheme.
  • In India, any investment scheme should have government’s approval. Approval would be in the form of licenses or registration numbers.
  • The constitution of the business as a company under the companies Act, ISO certifications, testimonials from high officials etc does not guarantee that the scheme operated by the company is legal.
  • Never pay cash. Always pay by cheque and get a receipt for the same. Cheques paid should be a crossed  account payee cheque in favour of the the company or scheme name.

DO A COST BENEFIT ANALYSIS

The costs should justify the benefits. Some investments carry a lot of hidden charges. It’s hidden in the sense that, those charges will be disclosed in the offer document in such a way that you get confused about the way in which those charges would be applied.

ASSESS THE RISK OF INVESTMENT

The thumb rule is- higher the return, higher the risk. There is no such thing called low risk-high return investment. All investment carry risk and the degree of risk increases as the expected rate of return increases.

KNOW THE LIQUIDITY AND SAFETY ASPECTS

Your investment should be liquid, ie, it should be convertible into cash quickly. Also evaluate the after tax return on investments.  Most of the investment schemes talk about returns before tax.

COMPARE

At any point of time, you‘ll have many investment opportunities in front of you. List out your objectives and financial goals first. Then, analyze whether those investments would help to meet your financial goals. Also compare it with similar investment schemes offered by other companies.

DEAL THROUGH AUTHORIZED INTERMEDIARIES

Most of the investment companies use the help of intermediaries to generate business. For example- mutual funds are sold through AMFI certified agents. Make sure that the agent that represents that company is qualified to do so. Ask all the clarifications you need to the intermediary.

SEARCH THE WEB

The internet is full of information about any topic you need. Search the net before you talk to the representative. The net will contain reviews by experts on investment schemes. Read at least 3 or 4 reviews. Since these are written by people who are already experienced, it would benefit you a lot.

WHAT IF SOMETHING GOES WRONG?

Explore the options available to you if something were to go wrong; Is there a regulatory body who would address your grievances? Do they have a local office in your state? After all this,  if you are satisfied, make the investment.

What’s said above is the minimum level of understanding you should have before embarking on an investment. Take care !

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Which investment is best for you?


This is one common question that wannabe investors ask. They want to know which type of investment is better for them in terms of returns. Before deciding what assets suites you best, you need to the following questions.

  • How much money do you have ?
  • How long are you willing to stay invested?
  • How much risk you’re wiling to take?
  • At what age do you plan to start investing?
  • What’s the degree of liquidity (convertibility into cash) you require?

The first factor is your financial capacity. You can enter the field of real estate investing only f you have a lot of money, say at least 15 to 20 lakhs. That’s minimum investment at this point of time. Arts and antique investments will cost you even more. So these types of investments are not for a person with very limited funds. Such investors can think of investing in gold or stocks or mutual funds since the initial amount required is very less.

As a general rule, all assets grow in value as time goes. So it doesn’t really matter where you’re invested in. For example – If you had invested in the shares of Wipro 25 years back, very few real estate investments can surpass the wealth you would have made. On the other hand, assume that you had invested in a beach front property in Mumbai in the 70’s. 40 years later, the wealth that has been created would be huge. What would be your wealth had you invested Rs 100000 in gold in 1970? It was just Rs 184 for 10 grams in 1970; today it’s approximately 26,000 for the same. Imagine the money you would have made. So, in the long term, all assets would create wealth. How long are you willing to stay invested?

The age at which you start investing is another important factor to be discussed here. For example consider any of the examples above. If you were at the age of 50 when you invested , any of these investments would have grown in the same way, but by the time you achieve these results, you’d at 90 or even more. So that’s another point consider. If you’re investing for your next generation, age is no problem at all.

All investments carry risk. When you invest in an asset, it’s possible that its value may gyrate illogically. You should know how to handle risk and for that, you should asses you risk bearing capacity. For example, if you are not wiling to take any risk your only option is to invest in fixed deposits of banks, government bonds and gold.

We are listing down the pros and cons of different types of investments. You should be able to choose which works best for you after reading this.

REAL ESTATE-Comfortable Investment.

  • Real estate investments involve huge amounts of money.
  • Unlike stock, here you buy something which you can see and feel. You buy it after physically inspecting it.
  • It’s a traditional investing option which everyone is comfortable with.
  • It’s comparatively difficult to be defrauded in real estate investments.
  • The property has to be safely guarded.
  • As time moves on the land keep appreciating in value whereas the building it it keeps depreciating in value.
  • You should be willing to wait at least 6 -10 years to get a solid return.
  • Liquidity is low when compared to stocks. To sell a property, it may take 3 or 4 months.

GOLD – Solid & safe investment:

  • Gold is considered as a safe investment, an insurance against inflation.
  • It’s a consistent performer.
  • It’s difficult to store gold. Security is a major issue. Even if you keep gold in bank lockers, most of the lockers provided by the banks do not have insurance cover.
  • You can start investing with little money.
  • Gold investments can be done through ETF route. ETFs are instruments that invest in 99.5 per cent purity gold. . Every unit of gold ETF you invest is euivqlent to 1 gram of physical gold. All you need for investing in gold ETFs is a demat account and a trading account with a broker.

STOCKS – The greatest wealth creator.

  • In-spite all of the stock-market crashes, stocks are one of the greatest wealth creators for investors.
  • Stocks give business ownership. For example, when you buy shares in Infosys, you are the owner of Infosys to that extent. You benefit from the company’s profits. The shares of highly profitable companies rise in value over a period of time.
  • They also pay their shareholders a portion of their profits in the form of dividends and bonuses. Hence you benefit both ways- increase in value of the share and dividends.
  • Diversification is easy when you invest in stocks.
  • All it takes is a little investment. With as little as Rs 10,000 you can start investing in companies.
  • Liquidity is very high. You can sell you shares in the secondary market within seconds and take your money.
  • It’s easy to be defrauded in stock markets. The world’s best auditors may be in control, there may be strict laws that govern companies but still- It’s easy to be defrauded in share markets.

ART AND ANTIQUES: It’s complicated.

  • Art and Antiques are interesting and profitable alternatives, but it is also extremely risky.
  • Art can never be considered as financial asset.
  • There are no proper yardsticks for measuring arts.
  • It’s highly illiquid and there is no organized market to buy and sell arts.
  • The investment required is very high.
  • It would be very difficult to store and protect art pieces.

FIXED DEPOSITS:  Sure shots

  • These are the most liquid form of investment.
  • The return is already known and hence, you invest in it only if the percentage of return offered by the institution is agreeable for you. So, there no question of being dissatisfied with the returns.
  • You can plan your finances according to the money flow expected.

YOU CAN ALSO BALANCE YOUR INVESTMENTS TO GET THE BEST OF BOTH WORLDS-

For example –

If you are someone who knows the real estate field well, you can invest in the shares of real estate companies-

By doing that, you take part in the overall real estate boom in the country (and not in a particular area’s price hike). If you need money urgently, those Stocks can be sold in a matter of seconds. It offers liquidity that no real estate investment can match.

Let’s assume you have shares worth 40 lakhs in DLF and you urgently need 2 lakhs to meet your parent’s medical bill. You can immediately sell 5% of your shareholding and raise 2 lakhs or you can pledge your shares and immediately raise 2 lakhs.

Instead, assume that your money was invested in one of DLF’s apartment. Can you sell 5% of your Flat? No. The only option is to either pledge you’re flat or borrow money. Both takes time.

CONCLUSION.

Having explained so far, now it’s your call.–Go ahead according to your budget, knowledge and risk taking ability! And don’t forget our 22nd principle!

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