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Why risk is good

by Money Puzzle   ·  April 4, 2019   ·  

Why risk is good

by Money Puzzle   ·  April 4, 2019   ·  

Risk and return are sisters who walk hand in hand. But do you know why they need each other?

It is easier to explain this in context to our everyday lives. Would you say that getting on an aircraft is a risk? Statistically, yes. But does that mean you don’t fly? Not really. That’s because you routinely choose the outcome of reaching your destination as being desirable. You are probably right in doing so, because according to some estimates there is a 1 in 3 million chance of a fatality thanks to an airline crash. The risk exists of course, but there is a rare chance of occurrence. Contrast that with road travel where the chances of fatalities increase manifold, yet we are likely to travel a lot more by road than by air. But that’s only logically, because we need to travel more by road – the outcome of road travel involves daily benefit as opposed to air travel which doesn’t have an everyday relevance. For those of us who do travel daily by air say of business purposes, the odds of a crash increase or their risk goes up in line with the return they get from covering longer distances to reach their destination daily.

Here is the thing, in our daily lives we make the risk return choice almost subconsciously based on our needs. When it comes to investments, making this trade off somehow becomes much harder. Let’s dig in.

Ideally, in the long run you want your investment to deliver returns which at the minimum grow the value of your rupee or in other words beat inflation. More than that you want your money to earn enough in the long run so that you are able to sustain your lifestyle through your working and non-working (retirement) years. Now if you never step out of your house, you have eliminated all risk be it by road travel or air travel. You will also get nothing in return, you won’t meet people or see new places.

With your investment too if you want something in return, you need to take some risk. How much risk? If you put all your money in a fixed deposit, you will get a fixed return at an extremely low risk. But in most time periods your return will be sub optimal and sometimes even below inflation. A return that is less than the inflation in the economy means that your money is not growing even as much to cover the annual price rise, that’s really a loss in value rather than a return. So, how can you enhance this return experience in the long term?

If you never step out of your house, you have eliminated all risk be it by road travel or air travel. You will also get nothing in return, you won’t meet people or see new places.

You will have to take on some risk. In the spectrum of financial investments, fixed income is considered low risk and equity is high risk. You can combine the two in some proportion and achieve moderate risk.

The amount of risk you need to take depends on the outcome you want to achieve. If you want to double your money in a year, that’s a 100% return. Compare that with the 6.5% extremely low risk you have with a fixed deposit, you will realise that to achieve this kind of return you must take a very high risk. The daily business flyer is taking more risk than the once a year holiday flyer. What does taking more risk entail? It means that you could double your investment in a year, but also be ready to lose half of it. That is what risk is – the up and down change in asset prices over a period of time. If you can sustain heavy loss in capital, then you can risk investing it in an asset that can potentially double your money in a year.

Ordinarily though, most of us aren’t that risk loving and will settle for inflation plus returns over a period of time. To achieve this outcome, while you will have to take on higher risk than just investing in fixed deposits, you need not plunge into risky money doubling schemes, or real estate buys, or even penny stocks which profess the ability to give you multiple times return.

What you will have to do is add on calculated risk. Equity is one financial asset which is easily accessible and has shown to be a viable option in giving inflation plus returns in the long run. You add a little equity risk with some fixed income to get a reasonable 10%-12% per annum post tax return in a 5-7 year period. It will take longer – say around 6 years to double your money at 12% and around 7.5 years to double your money at 10% annualised return – but your chance of losing money also goes down dramatically. In fact, for equity investments, historical data shows that beyond 10 years holding period only a 1% chance that your returns will be negative.

That is why some calculated risk is good – it brings you return.

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