Learn how to manage risk in your investment portfolio through proper fund allocation and diversification of your assets.
To most people, risk evokes a negative image. When we mention risk in terms of investment, people might think about losing their savings. However, in reality, investment risk comes in different forms, and each can affect the way you pursue your financial goals. The key to deal with varying risks of investment is learning how to manage it.
Step one: Understand the different risks involved in investment
Investment risk is generally derived as the probability that the actual returns on your investment will be lower than expected. Fear of losing money is probably the reason why people choose conservative investment options. While investment risk refers to the loss of money, it can be further classified into different categories. Familiarizing yourself with different types of investment risks is the first step in learning how to manage risk in your portfolio.
Market risk: Market risk is also known as systematic risk. The value of your investment will move with the overall market performance. For instance, if the stock market is experiencing a decline, the equity mutual funds in your investment portfolio may decline as well.
Interest rate risk: Interest rate risk is most commonly associated with fixed-income investments. This is the case where the price of the security will fall with the rising interest rates.
Inflation risk: It is a risk in which the value of your portfolio will reduce. There will be a decline in the purchasing power of your savings because of inflation. It is crucial to consider inflation risk while evaluating traditional investments such as money market funds, bond funds, and fixed deposits. Your investment may earn returns; however, it may actually lose its value and fail to keep pace with the inflation rate.
Credit risk: Credit risk generally comes with debt funds. It refers to the bond issuer's ability to repay the money as promised when the fund matures. CIBIL and CRISIL give such debt funds credit ratings. Higher the score, lower the credit risk, and vice versa.
Step two: Manage the risk with diverse investment
"Don't put all your eggs in one basket", the old cliché is pretty applicable in the world of investment. Diversification means investing your money among several different options. It is used explicitly to manage the market risk in your portfolio. Mutual funds can be an ideal way to diversify your portfolio as they invest in many different securities.
Selecting more than one type of investment can further help you manage your risk. You may invest in safer investment options such as bank FD and PPF to diversify the market risk. There are potential benefits of investing money in more than one asset class. When stocks are particularly hard hit due to market fluctuations, bank FD and government bonds may not be affected as dramatically.
Step three: Match your investment to your financial goals
Before you decide which type of investment options are appropriate to manage the risk, it is advisable to evaluate your investment goals. Is your investment goal preservation of capital, generating income for regular expenses, or building value of your principal amount over and above inflation? Your answer will enable you to find a balance between the return you hope to receive and the risk you are willing to take.
Step 4: Match the time period with your investment options
It is crucial to examine the time period to meet your financial goals with each investment option that you consider. Think about how comfortable you may be bearing short term losses in the value of your capital. Remember, the longer your time horizon for the investment, the more volatility you can expect in your portfolio. At the same time, consider inflation if you are investing for the long term. When you are investing in building a retirement corpus, you may also be concerned about building capital over a period of time.
For instance, investors pursuing long-term goals will be more concerned about the inflation risk. Their portfolio will likely be more heavily weighted with stock investments as stocks have historically given the highest long-term returns and outperformed to beat inflation risk. However, stocks performance does not guarantee future profits. These investors may also invest in money market instruments to help balance the higher risk associated with stocks. It is important to note that stocks provide long-term growth potential, but can fluctuate and offer less current income than other types of investments.
On the other hand, people who are retired may need to rely heavily on income from their investments. Thus, they may seek to manage income and risk of short-term losses. Their portfolio may include high quality, low-risk investment options such as government bonds and bank FDs.
Inappropriate investments – The unseen risk in investment
When you think about managing risk and return in your investment portfolio, don't forget that the risk of loss is not the only type of risk. Give a thought to the risk of investing money in a conservative option and not reaping enough returns for your future. Moreover, be aware of investing money in such instruments that may be too risky for your short-term financial goals. You may take the help of a financial professional who can help you in the selection of investment vehicles that are most suitable for your investment objectives. As you consider a number of potential investment options, research their past performance and risk characteristics. For instance, if you consider stocks of a particular company, how drastically has it responded to the market volatility? How long has it taken to recover losses? How good has it performed over a time frame similar to your investment horizon?
Risk has its potential rewards
In life, with every attempt at success, there is a bit of risk involved. And your investment strategy is no exception. You can learn how to manage risk in your investment portfolio by
- Devoting time to study your investment portfolio
- Conducting market research
- Working with a financial professional to choose appropriate investments.
These are some fundamental concepts and critical concerns of your investment success. When you plan to build an investment portfolio, don't forget to consider these concerns.