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Both risk and return count in investing − Money Essentials #4

by Money Puzzle   ·  February 25, 2022   ·  

More often than not, the decision around where to invest rests on the returns you get. Thinking only of return can blind you to the risk. In fact, before you consider how much return you will make, it’s better to consider the risk you are taking.

Risk comes in different forms. Firstly, there is the risk of losing capital, which can often accompany promises and guarantees of very high returns. This risk is also present in unregulated investments and when the investment is not made in your name.

The second type of risk is volatility. This is the risk that is seen in market-linked investments like mutual funds and listed stocks and bonds. Volatility means that the daily value or price of the investment will move up and down based on both internal factors and external market-related factors. Some amount of daily volatility is acceptable in long term investments which you will hold for many years.

In the third place, we should discuss inflation risk. This risk shows up when you invest in a security where the return is lower than the yearly inflation or price rise in the economy. Inflation reduces the value of money and if your return is lower than inflation, you are not growing your savings. Rather they are losing value.

Fourth, we must talk about default risk. This is the risk that you can potentially lose interest payouts and may not even get your capital back from an investment made in a corporate bond or NCD. When companies are unable to generate cash to pay their bondholders, they default and the investor loses out.

Lastly, there is liquidity risk. This risk means that you are unable to sell your investment when you want to and at the price, you want to. This risk is seen in listed stocks of smaller sized companies and low-quality corporate bonds. It is also very common in real estate investments, where sales can happen at distress value in the absence of a ready buyer. Investing without knowing the risk involved might mislead the return expectation you have from an investment or asset. Be sure to first check the risk and then determine whether the return is suitable or not and whether that investment is worth your while or not.

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