Taking a Little Risk is Good for Your Investments - Here's How and Why to do it
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There's a lot of talk about the element of risk involved in investing. And the general consensus seems to be that investors should avoid risk as much as possible. But is risk really that bad for your investments? Or is there actually some kind of advantage that you can experience by taking on a calculated amount of risk?
To understand the answers to these questions, let's begin by discussing what risk is all about.
What is investment risk?
Investment risk is simply the possibility that your investment could result in a loss. When you invest your initial capital in an asset, you cannot entirely predict how that asset will perform in the future. The actual returns the asset delivers may be higher or lower than the returns you expect the asset to offer.
If the actual returns are higher than the expected returns, you earn profits. But if the actual returns are lower than the expected returns, you suffer a loss. The possibility of a loss increases if it's harder to predict how an asset will perform in the future. This is why some investment options carry a higher risk than others.
Simply put, if the difference between the expected returns and the actual returns from an investment is higher, the risk associated with this investment option also rises. Let us take a look at two different investment avenues on the opposite ends of the risk spectrum to understand this better.
Low risk investment: Fixed deposits
Say you invest Rs. 1 lakh in a fixed deposit. The bank offers interest at the rate of 6% per annum. So, you make use of an FD calculator and find that if you invest in this instrument for 5 years, you will earn Rs. 34,686 at the end of this period. After 5 years, your money would have grown to around Rs. 1,34,686, since the returns of 6% are as good as guaranteed by your fixed deposit.
High risk investment: Direct equity
Now, let's assume you wish to invest in direct equity. You choose to invest the same Rs. 1 lakh in the equity shares of a company that has delivered an average annual return of 15% over the past 5 years. You expect it will perform in a similar manner over the next 5 years. However, owing to many external and internal factors, the stock only delivers a return of 10% on average each year.
So, as you can see, the risk is higher in this case.
But risk can be good for your investments too
Before you write off risk as an unnecessary element of investing, there's something else you need to know. Taking a calculated risk in your investment strategy can pay off greatly, particularly over the long term. This is because risk and rewards are intricately connected. In most cases, the higher the risk involved, the greater the chances of earning higher returns.
Take the same two investment options we saw earlier. In guaranteed investments like fixed deposits, the rate of return is typically lower. However, in high risk investments like equity, the chances of earning higher, double-digit returns also rises.
Benchmark index Nifty delivered historical returns of around 53% in the last year. And the BSE Sensex delivered historical returns of around 50% over the same period.
Including a calculated amount of risk in your portfolio also comes with many other advantages. Here are the top benefits of embracing a little bit of investment risk.
- Wealth creation over the long term
- Inflation beating returns
That said, the returns from the equity market are also more unpredictable than the returns offered by guaranteed investment options. So, the chances of making losses also rises. This may put off conservative investors and attract aggressive, risk-taking investors instead. But the trick is to strike a balance between risk and reward.
How to balance risk and reward in your portfolio?
As far as risk goes, not all investments fare equally. So, not all high risk investments offer comparable rewards. Equity, for instance, is a high risk investment that comes with the potential to earn inflation beating returns. Derivatives, on the other hand, may be equally risky, but the returns may not be comparable over the long term.
The end goal is to balance risk and reward, so that the risk is minimized and the rewards are maximized. Here are some tips to help you strike this balance.
Assess your risk appetite
You need to be aware of the maximum level of risk that you can afford to take. If, for some reason, you are unable to take on higher amounts of risk, it makes more financial sense to choose safer investment options until you are ready to absorb more risk. As the popular line goes — Only invest as much money as you are comfortable losing.
That said, if you are comfortable taking on more risk, it's a smart idea to do that earlier in life, when you have time on your side.
Diversify your investments
Ideally, your portfolio should include a wide range of investment options across the risk spectrum. That way, the low risk assets can set off any losses from the high risk investments, and the high risk assets can help your investment value multiply over the long term, thanks to inflation beating returns.
Revisit and rebalance your portfolio
Rebalancing your portfolio from time to time helps you maintain the right risk-reward ratio for your specific investor persona. Over time, your risk tolerance may increase or decrease, based on your financial status and life goals. Your portfolio must reflect these changes. And rebalancing makes this possible.
Top high-risk-high-reward investment options for your portfolio
If you're interested in introducing a little bit of risk into your investment portfolio, here are some investment options to consider.
Initial Public Offerings (IPOs)
IPOs are flooding the Indian equity market now. And by investing in the first issue of a fundamentally strong company, you can get started on your wealth creation journey. Or, if you have a short-term horizon in mind, you can even enjoy some listing gains in the process.
Equity mutual funds
Equity mutual funds allow you to enjoy the high returns offered by the equity market without the hassle of planning your entry and exit on your own. That's because mutual funds are generally managed by fund managers who have several years of experience backing them up.
REITs allow you to invest in companies that in turn invest in income-generating real estate commercial and residential properties. This way, you can diversify your portfolio with real estate investments even if you do not have the lump sum amount needed to buy property.
Index funds allow you to invest passively in the stock market. These funds track the benchmark indices and allow you to enjoy the rewards they offer, without having to take on the trouble of timing the market yourself.
In addition to the above options, there's one other financial product that helps you enjoy the dual advantage of insurance and investing. And that's the Unit Linked Insurance Plan (ULIP). A ULIP like the ABSLI Wealth Assure Plus gives you a life cover and also allows you to invest in various market-linked funds like equity funds, debt funds, and balanced funds, among others. You can even switch funds each policy year, so you can effectively modify your investment portfolio as your risk-reward profile changes.
The bottom line is the higher the risk, the better the returns may be. So, in order to give yourself the opportunity to create wealth over the long term, taking some amount of risk may be necessary. Remember to adjust your portfolio over time, so you can manage the amount of risk as you age.
Read next: 5 STEPS TO SELECTING THE RIGHT INVESTMENT FOR YOU
Risk is just one of the many things to consider when you are building your investment portfolio. One of our blogs outlines five steps to select the right investment for yourself. Want to know more?
OFFSET SOME OF YOUR RISKS WITH GUARANTEED LONG-TERM INCOME
The ABSLI Assured Income Plus gives you guaranteed income benefits for 20, 25 or even 30 years! All you need to do to be eligible for these benefits is pay your premiums on time for a very short period.
And that's not all. This plan also gives you the option to choose the Income Benefit with Return of Premium variant. That means you can earn regular income and get your premiums back.
ABSLI Assured Income Plus (UIN: 109N127V04) is a non-linked non-participating individual life insurance savings plan. GST and any other applicable taxes will be added (extra) to your premium and levied as per extant tax laws. An extra premium may be charged as per our then existing underwriting guidelines for substandard lives, smokers or people having hazardous occupations etc. For policies issued on minor life, the date of commencement of risk shall be the date of commencement of the policy. Where a policy is issued on a minor life, the policy will vest after attainment of majority of the Life Insured. Where the Life Insured (whether major or minor) and Proposer/Policyholder is different, on the death of the Proposer/Policyholder, his legal heirs, in accordance with the existing succession laws, will be considered as new Proposer/Policyholder. As there is no death benefit payable on the death of the Proposer/Policyholder, the policy status does not change, and the policy continues.
ABSLI Wealth Assure Plus (UIN: 109L120V02) is a non-participating unit linked life insurance plan. Aditya Birla Sun Life Insurance and ABSLI Wealth Assure Plus are only the names of the Company and Policy respectively and do not in any way indicate their quality, future prospects or returns. The name of the funds offered in this plan does not in any indicate their quality, future prospects or returns. The Past performance of the Unit linked fund(s) of the company is not necessarily indicative of the future performance of any of these Unit linked fund(s). The charges are guaranteed throughout the term of the policy unless specifically mentioned and subject to IRDAI approval. The value of the segregated fund reflects the value of the underlying investments. These investments are subject to market risks and change in fundamentals such as tax rates etc affecting the investment portfolio. Please know the associated risks and the applicable charges, from your Insurance agent or the Intermediary or policy document. The premium paid in non - participating unit linked life insurance policies are subject to investment risk associated with capital markets and the unit price of the units may go up or down based on the performance of segregated fund and factors influencing the capital market and the policyholder is responsible for his/her decisions. There is no guarantee or assurance of returns above the guaranteed returns from the segregated funds. Goods and Service Tax and any other applicable taxes levied as per extant tax laws shall be deducted from the premium or from the allotted units as applicable. An extra premium may be charged as per our then existing underwriting guidelines for substandard lives.
ABSLI Life Shield Plan
A term insurance plan that offers you the flexibility of plan options suitable for your family's non- negotiable goals and ensure they need not compromise on their lifestyle. UIN: 109N109V06
- Choice of 8 plan options
- Cover your spouse under the same policy
- Longer Life cover till age 85
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