We have discussed about Inflation, which is a very important part of building Wealth. The other important thing to consider is Risk.
Risk basically measures the probability of you losing your money/capital. Why do you need to understand Risk to invest? Because, everything about investment/building wealth revolves around risk. Higher the risk, higher the returns on your investments. As you are taking more risk, you get paid more, either as interest or dividends or price of your investment etc.
There is not clear measure of Risk. It is more of a approximate measure and that is why I mentioned it is a probability. You may still loose money in a low risk investment, but the probability of that happening is very low.
Also not everyone is able to handle the same amount of risk. So it is important that you understand how much risk you are ready to take and plan your investment strategy accordingly. If you want to take low risk, be ready to accept lower returns. If you want to get 20% returns, then be ready to take the kind of risks that involves. One of the things that has happened recently in India is the wide spread availability of Mutual Funds and ULIP policies which are purchased by people without any idea of the risk that entails. A lot of the selling of these investments are via agents who work on commission basis and so do not explain the kind of risks involved to the investor. This can lead to shocks to the investor when he looses a large part of the capital during a downturn (as is currently happening around the world).
Your risk appetite is dependent on a number of factors. Some of these are:
- Personality
- Age - The older you are the less risk you should take
- Investment Expectations - If you expect higher returns, you may be ready to take more risk
- Investment Timeframe - If you have a longer timeframe for the investment you may be able to take more risk, as you have more time to make up for losses
- Income and Wealth - Historical data shows that higher income or wealth the more risk you may be ready to take
A number of financial planners have a questionnaire that will help you identify your risk profile. There are also a couple of portfolio or brokerages that provide a risk profile option to their clients. It is very important that you identify what your risk profile is as it will directly impact the decisions you will take about your portfolio, which will affect the growth of your wealth.
The basic rule of investment is more the risk of the investment the more the returns. For example, Fixed Deposits are considered quite safe. But even in those there may be difference in rates between a public bank, private bank or a private company. Obviously the risk rises as we move from public bank to a private company and that you will see reflected in the interest rates. Also this may not be the actual risk, but rather the perceived risk. For example, there may not be no major difference in risk between a public or a private bank, but if investors see one of them as less safe, they would bring their money in only if the return matches their perception.
Risk is an integral part of investing and recognizing that is the first step toward successful investing.
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