There is a simple two-step formula to become "rich".
Step 1: Take 'Risk'
Step 2: Replace the last two letters 'sk' with two new letters 'ch'
That's it! You become 'Rich'.
It's quite clear that all the magic lies in the 2nd step.
So, let's see how we can delete 'sk' from risk and add 'ch' to it.
But, before we plunge into the discussion, it is important to note that Money and Risk are two sides of the same coin.
Even if you do nothing — and keep your money under the proverbial carpet — its value will constantly erode. Reason? Of course, Inflation.
Keep Rs.1 lakh under the carpet, and few years later it won't fetch you even half the things as it can do today.
So, hoarding cash is NOT SAFE (and I am not talking of the 'risk' of demonetization or theft). Like a termite, inflation will simply eat away your money and make it USELESS.
So, you must invest your money somewhere, to earn returns on it. This is the ONLY way to keep your money SAFE and USEFUL.
Where you invest your money, determines the type of risk your money faces. Consequently, the type of risk-protection measures that you need to take, too differ.
If you don't receive interest and / or principal on your fixed deposit with a bank or company, it becomes a default risk. This is also known as credit risk. You are taking risk on the credit worthiness of the borrower.
Investments that face default risk include fixed deposits, bonds and debentures.
To minimize the risk of losing money to a default, it is but natural that you must choose the borrower with extreme care and diligence.
The most obvious strategy is to avoid schemes offering "abnormally" high interest rates.
No one would willingly give high returns. As such, in such schemes either (a) the borrower is taking too much risk in his business or (b) he has no intention of returning your money. Unrealistic promises = High risk of default.
To keep your money safe, don't look at such 'risky' deposits at all. It is much better to invest only in large, reputed and profitable companies or banks; with proven track record of timely payment.
Another option is to study the credit rating of the scheme. Assessed by independent agencies like CRISIL, CARE etc., these ratings (like AAA, AA, BB, etc.) indicate the level of safety. Better the rating, lower is the risk of default.
While these measures will not 100% eliminate the risk of default, you would have at least minimized the chances of the same.
When the value of your investment is determined by the market and fluctuates with the same, it is known as market risk.
Equity shares and equity mutual funds are the best examples of investments susceptible to market risk.
It has been mentioned by umpteen experts — time and again — that companies with good businesses will generally be profitable. This will often translate into appreciation in their share prices. Therefore, to minimize the threat of market risk, it is logically that you must buy stocks of "many" and "successful" companies.
Most investors can very easily achieve this, by buying units of well-performing equity mutual funds. Professional management and diversified portfolios will sharply reduce the market risk.
The day-to-day market fluctuations i.e. volatility can be easily countered by not making large lump sum one-time investments. Instead, you must spread out your investments. In mutual funds, this is achieved through SIPs (Systematic Investment Planning).
Last but not the least, you have to give time to equity investments. It has been historically proven that, as your investment time-frame increases, the risk of losses dip sharply.
Implement these tips and there is no reason whatsoever, why you should worry at all about the market risk.
As discussed, because of inflation you can't keep too much cash idle at home.
Also, because of very low interest rates, you can't keep too much idle cash in the bank Savings Accounts.
But, when you invest your money, sometimes it may not be possible to encash it prematurely (e.g. PPF, EPF or ELSS). Or, the costs involved are simply too high (e.g. surrendering your insurance policy). This is nothing but Liquidity Risk i.e. you cannot access your money easily or cost-effectively in case of an emergency.
To manage this risk, you need to keep a nominal sum, say around 2 to 4 months of your average monthly expenses, in a bank fixed deposit. This can be encashed easily and with minimum cost.
Secondly, your investment portfolio should have an appropriate mix of short-term (e.g. fixed deposits, short term debt funds), medium-term (e.g. bonds, income funds, balanced funds, gold) and long-term products (e.g. PPF, equity). This will minimize liquidity risk, without compromising on the returns.
Another great option is to have a lifetime free credit card. This gives you access to instant cash, without any of your own money getting locked-in in some investment. Needless to mention, this should be used selectively only when there is an emergency.
In recent times, changes in the interest rates have become more frequent and more pronounced. Even the safe and steady Govt. schemes like PPF, Post Office Monthly Income Scheme, Sr. Citizen Scheme, etc. are no longer the same... their interest rates can change every quarter. And bank FD rates change quite often.
This calls for caution, to avoid getting stuck in low-interest deposits.
If the economic conditions are such that the interest rates may rise, you should ideally avoid long term deposits. You need to wait till the rates go up, before you lock-in your money for longer periods. Alternatively, if the rates are expected to drop, you should immediately invest in long term deposits.
Debt mutual funds (an excellent alternative to fixed deposits, especially for high tax payers) are a different breed and hence require some understanding.
In short, whether it is the all-time favourite fixed deposits or the latest innovation debt mutual funds, you have to be aware of the interest rate movements and time your investments correctly.
Concluding, in today's highly dynamic world, "Risk Avoidance" is not an option at all.
So, the earlier you learn and master "Risk Management" the better it is for your financial prosperity. Moreover, as we have seen, this is no rocket science.
My mantra: AVOID SAFETY. PROTECT RISK.
Step 1: Take 'Risk'
Step 2: Replace the last two letters 'sk' with two new letters 'ch'
That's it! You become 'Rich'.
It's quite clear that all the magic lies in the 2nd step.
So, let's see how we can delete 'sk' from risk and add 'ch' to it.
But, before we plunge into the discussion, it is important to note that Money and Risk are two sides of the same coin.
Even if you do nothing — and keep your money under the proverbial carpet — its value will constantly erode. Reason? Of course, Inflation.
Keep Rs.1 lakh under the carpet, and few years later it won't fetch you even half the things as it can do today.
So, hoarding cash is NOT SAFE (and I am not talking of the 'risk' of demonetization or theft). Like a termite, inflation will simply eat away your money and make it USELESS.
So, you must invest your money somewhere, to earn returns on it. This is the ONLY way to keep your money SAFE and USEFUL.
Where you invest your money, determines the type of risk your money faces. Consequently, the type of risk-protection measures that you need to take, too differ.
1. Default Risk
This risk is simple to understand.If you don't receive interest and / or principal on your fixed deposit with a bank or company, it becomes a default risk. This is also known as credit risk. You are taking risk on the credit worthiness of the borrower.
Investments that face default risk include fixed deposits, bonds and debentures.
To minimize the risk of losing money to a default, it is but natural that you must choose the borrower with extreme care and diligence.
The most obvious strategy is to avoid schemes offering "abnormally" high interest rates.
No one would willingly give high returns. As such, in such schemes either (a) the borrower is taking too much risk in his business or (b) he has no intention of returning your money. Unrealistic promises = High risk of default.
To keep your money safe, don't look at such 'risky' deposits at all. It is much better to invest only in large, reputed and profitable companies or banks; with proven track record of timely payment.
Another option is to study the credit rating of the scheme. Assessed by independent agencies like CRISIL, CARE etc., these ratings (like AAA, AA, BB, etc.) indicate the level of safety. Better the rating, lower is the risk of default.
While these measures will not 100% eliminate the risk of default, you would have at least minimized the chances of the same.
2. Market Risk
This risk too is easily understood by all.When the value of your investment is determined by the market and fluctuates with the same, it is known as market risk.
Equity shares and equity mutual funds are the best examples of investments susceptible to market risk.
It has been mentioned by umpteen experts — time and again — that companies with good businesses will generally be profitable. This will often translate into appreciation in their share prices. Therefore, to minimize the threat of market risk, it is logically that you must buy stocks of "many" and "successful" companies.
Most investors can very easily achieve this, by buying units of well-performing equity mutual funds. Professional management and diversified portfolios will sharply reduce the market risk.
The day-to-day market fluctuations i.e. volatility can be easily countered by not making large lump sum one-time investments. Instead, you must spread out your investments. In mutual funds, this is achieved through SIPs (Systematic Investment Planning).
Last but not the least, you have to give time to equity investments. It has been historically proven that, as your investment time-frame increases, the risk of losses dip sharply.
Implement these tips and there is no reason whatsoever, why you should worry at all about the market risk.
 |
| Your money is under serious threat. Make sure you know how to protect it. |
3. Liquidity Risk
Not many people appreciate this risk... until some calamity hits them.As discussed, because of inflation you can't keep too much cash idle at home.
Also, because of very low interest rates, you can't keep too much idle cash in the bank Savings Accounts.
But, when you invest your money, sometimes it may not be possible to encash it prematurely (e.g. PPF, EPF or ELSS). Or, the costs involved are simply too high (e.g. surrendering your insurance policy). This is nothing but Liquidity Risk i.e. you cannot access your money easily or cost-effectively in case of an emergency.
To manage this risk, you need to keep a nominal sum, say around 2 to 4 months of your average monthly expenses, in a bank fixed deposit. This can be encashed easily and with minimum cost.
Secondly, your investment portfolio should have an appropriate mix of short-term (e.g. fixed deposits, short term debt funds), medium-term (e.g. bonds, income funds, balanced funds, gold) and long-term products (e.g. PPF, equity). This will minimize liquidity risk, without compromising on the returns.
Another great option is to have a lifetime free credit card. This gives you access to instant cash, without any of your own money getting locked-in in some investment. Needless to mention, this should be used selectively only when there is an emergency.
4. Interest Rate risk
This probably is the least understood risk.In recent times, changes in the interest rates have become more frequent and more pronounced. Even the safe and steady Govt. schemes like PPF, Post Office Monthly Income Scheme, Sr. Citizen Scheme, etc. are no longer the same... their interest rates can change every quarter. And bank FD rates change quite often.
This calls for caution, to avoid getting stuck in low-interest deposits.
If the economic conditions are such that the interest rates may rise, you should ideally avoid long term deposits. You need to wait till the rates go up, before you lock-in your money for longer periods. Alternatively, if the rates are expected to drop, you should immediately invest in long term deposits.
Debt mutual funds (an excellent alternative to fixed deposits, especially for high tax payers) are a different breed and hence require some understanding.
- Interest rates and NAVs of debt mutual funds are INVERSELY related. So, if rates go up, your NAV will come down. Vice versa, if rates go down, your NAV will appreciate.
- Secondly, long term debt funds suffer more depreciation (or offer higher gains) with interest rate movement, as compared to short term funds.
In short, whether it is the all-time favourite fixed deposits or the latest innovation debt mutual funds, you have to be aware of the interest rate movements and time your investments correctly.
Concluding, in today's highly dynamic world, "Risk Avoidance" is not an option at all.
So, the earlier you learn and master "Risk Management" the better it is for your financial prosperity. Moreover, as we have seen, this is no rocket science.
My mantra: AVOID SAFETY. PROTECT RISK.
