While risk is a dreaded word for many when it comes to taking decisions or putting in place a plan or strategy,you just cannot wish it away. Accepting it and treating it as your friend holds the key for success.
Financial risk can be divided into following categories: Basic risk,capital risk,country risk,default risk,delivery risk,economic risk,exchange rate risk,interest rate risk,liquidity risk,operations risk and payment system risk. Now that you have categorised risks into various classes,do you have a process in place while executing your investment decisions?
Risk management in investment process
Leonardo Da Vinci once said: Knowing is not enough,we must apply. And applying the information on risk is the key driver to wealth creation or destruction. Let us look at risk from an investment process while considering the various types of risk.
With the interest rates expected to go south,you know that longer-term bonds are likely to deliver higher returns because there is the interest rate risk and reinvestment risk involved (interest rate risk because as the interest rates goes south,investment for shorter terms will deliver a lower rate of return. Reinvestment risk because when the investment matures and,if the interest rates are going south,then you will have to reinvest at the prevailing rate,which could be lower than the original investment return rate).
If the investments are in lower quality products,there is the default risk as well. If,as an investor,you have multi-country geographical investments,country and exchange rate risks will also need to be factored in.
So,investing is not a simple task. Having said that,if you have a process in place,it becomes quite easy. And that is where you need to have the process in place for risk management. You can put in place a process only if you know what are the risks you need to consider at the time of investing.
Risk and volatility
Post-2008,risk management is being closely looked into. However,investors today are confused between volatility and risk. Both are used interchangeably,which is wrong.
Volatility,in simple terms,is tending to fluctuate sharply and regularly. In investing parlance,volatility is a measure for variation of the price of a financial instrument over time. Is volatility a risk? The answer is both yes and no. Yes,if you are looking at a very short-term horizon where market indices fluctuate either sides,based on the news flow. No,if the time horizon is longer. This is as simple as it can get.
At the time of investing,it is very important that you know what you are getting into. And if you get confused between volatility and risk,it would not allow you to make the right decision.
Risk and return
The greater the risk,the higher the return. This statement needs to be revisited. Today,especially in case of bonds,you would have generated double-digit returns over a two-year period without taking additional risks. On the other hand,equity markets in India in the same period have delivered single-digit returns. Risk and return are co-related. One needs to look at risk at the time of investing as an in-built process and not separately.
Risk should not be a dreaded word. Build in risk in your investing process and decision-making mechanism and you will find risk to be an effective tool in the wealth creation process. Based on the changing situations,be it financial or geo-political,you need to revisit and make decisions accordingly. What can be controlled should be controlled and risk in the investing process at the early stages is a controllable factor.
The writer is founder & managing partner of Zeus WealthWays LLP