Why Is Risk Management An Essential Part Of Investment

Risk means uncertainty, and the possibility of an adverse event. In the investment world, it might be defined as the chance of an investment losing its value. It is important to understand the different types of risks so that you can manage them effectively.
Oct 2022
3 mins read

Depending on the types of assets you invest in, you will face one or more of the following investment risks:

Type of Investment RiskWhat it meansWhere it applies
Market RiskRisk of market fluctuations and volatilityMarket-linked investments like stocks and mutual funds
Credit RiskRisk of default on debt instruments by the financial institution Debt investments like fixed deposits, bonds etc.
Inflation RiskRisk that inflation would exceed investment returnsAll instruments where returns are lower than inflation
Interest Rate RiskRisk of interest rate fluctuationsFixed-income instruments like FDs, bonds etc.
Exchange Rate RiskRisk of fluctuation in the exchange rate of currenciesForeign exchange trading
Liquidity RiskRisk of not being able to convert your investments to liquid funds when neededReal estate

How to manage risk
Investment planning and risk management go hand in hand. There is no zero-risk investment option. Even when investing in fixed-income securities, you cannot avoid certain investment risks, but you can still manage them. Here’s how –

     1. Risk identification and assessment
         First, identify the risks inherent in different investment avenues. Next, assess your risk appetite, i.e. your capacity to handle investment risks. Your risk appetite usually depends on your:

  • Age
  • Financial goals
  • Investment objective
  • Investment horizon
  • Disposable income
  • Overall attitude towards risks

Once you know your risk appetite, you can pick investment avenues that align with it. Here are some examples:

Risk AppetiteMeaningSuitable investment avenues
High or AggressiveYou are willing to take high investment risks to earn higher returnsStocks, equity mutual funds, equity derivatives etc.
Low or ConservativeYou are risk-averse and want the minimum possible risk of investmentHigh-quality debt instruments like bank FDs, Government securities, bonds with high credit ratings etc.
ModerateYou are open to a moderate amount of investment riskA mix of equity and debt
   2. Portfolio diversification and asset allocation
Diversification means holding a variety of assets in your portfolio that have a negative or low correlation (‘correlation’, in investment parlance, means how two different assets perform historically in relation to each other). There is a positive correlation if the assets move in the same direction and a negative correlation if they don’t.

For example, in a volatile market, equities may be prone to a loss, but fixed deposits could be unaffected. Thus, the correlation between equity stocks and FDs is low in this case. On the other hand, both stocks and equity mutual funds might suffer losses in a volatile market. They would, thus, be positively correlated.

Similarly, asset allocation means allocating your investments to different types of assets. If you pick negatively correlated assets, the loss from one would be offset by the gain from another, thus reducing investment risk.

   3. Rupee-cost averaging
When investing in market-linked securities, timing the market is a challenging task. However, you can benefit from rupee-cost averaging through systematic investments like SIPs. It means that while your investment amount remains the same every month, the number of units you purchase vary based on market volatility. When the markets are peaking, you pick fewer units of a fund, and when the markets are bottoming out, you pick up more units.

   4. Buying insurance products
Insurance is a potent risk management tool. It involves transferring your financial risks to the insurance company, and the company compensates you for the loss suffered due to the insured risk. Insurance provides financial security and helps in emergency planning. Different insurance products safeguard you from different risks – to your belongings; to your health; and to your life.

Why does risk management matter?

It reduces risk
Through efficient risk management, you can reduce the chances of possible losses from investments and enhance the profitability of your portfolio. In fact, the whole purpose of risk management is to restrict investment risks while managing returns..

It secures your investments
By reducing the possibility of losses, risk management helps prevent the loss of your investments during adverse events. As a result, you can withstand short-term volatility, and your portfolio becomes resilient to such events.

It helps you maintain your lifestyle
When you safeguard your investments against possible losses, you are better positioned to increase or at least retain their true value, helping you maintain your financial position as well as your lifestyle.

To provide financial security to your family
Risk management helps you fulfil your financial goals. Moreover, in the case of your premature demise, your family will still remain financially secure if you have invested in life insurance to manage the risk of premature death.

Risk management is one of the pillars of financial planning and is a must for a sound financial portfolio. First, assess your risk tolerance, and then, design a diversified portfolio that aligns with your risk appetite, keeping in mind the essential investment planning tips. Finally, review your investments regularly to ensure that they match your risk profile and are resilient in the face of adversity.

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