Why you need to balance risk and return on investments

Risk and return on investments are often a neglected couple when it come to an investor’s portfolio. You either focus on risks or just returns. Risk-Return concepts are poorly understood.

In fact, if you think for a moment, you will realize that most of the investors focus much more on returns and less on risk. Agreed, you do question risk in a very subtle way like “Paisa to doob nahin jayega ?”, but those questions are few and far between.

Investors need to understand that risk and return both are an integral part of a person’s portfolio. While the concept of return on investment is something which is easy to understand, questions like ‘are risk and return’ related becomes tough to answer.

Risk and return on investments

Risk to an investor is the probability of losing his capital when he invests in an instrument. His intent is always to earn more money over and above his invested capital. If you want more returns, you will have to take more risk and if you want less returns, it could be got by taking less risk.

The stock market is a risky place to put your money in if the duration of your investment is short term – most readers are not aware of long term investing benefits and concepts.

It is important for us to know that not all investment avenues can generate positive returns always. The stock market and real estate usually move hand in hand. So when the stock market rises, people profit, pull out their monies and put in real estate. Real estate thrives in good economic conditions which gets reflected in a  healthy stock market index.

But generally when this happens, debt or fixed income instruments give subdued returns. It is only when the stock market falls do debt products begins to look attractive.

So, remember that equity and debt move in opposite directions.

Having understood that, it now looks very simple, that to make a portfolio with less risk, you need to put your eggs in many baskets and not just one.

1. Diversification – What this leads to is that all these investment products do not give a positive return always. So an intelligent investor needs to diversify his portfolio. Diversification is the art of spreading your money across many financial products so that the negative returns from some of them can be compensated by positive returns from others, thereby shielding your portfolio from disastrous results.

2. Pick products which move opposite to each other – An investor should choose products for his portfolio in such a way so that when one moves up to give positive returns, the others do not necessarily move up. The issue with that is that when you have products that move in the same direction, you get mind blowing returns when they give positive returns but you lose your shirt when they give negative returns.

It is always intelligent to mix and match products in your portfolio in such a way that the returns from them can come together to give a balanced return. This is the holy grail to managing risk in investments. Yo get this wrong and you will be sitting on the losing side of your life’s financial race.

Other Investment Risk Vs Return

So while we understand that the risk and return on investments can be managed by diversification, note that this does not take care of all the risk your portfolio is exposed to. The diversification strategy can manage your portfolio risk to some extent but cannot shield it from all the furies of nature.

You also need to be cognizant of a product risk. Let us take an example. Suppose you buy shares of Infosys Ltd. (what an example, eh ?) !

Now, the risk you are carrying on buying Infosys is dependent on how the company does quarter on quarter. No one else outside of the Infosys organization can help mitigate that. Once you buy the scrip you have locked into the risk that you carry with this product. Yes, you are right if you are thinking that you need to buy another stock if you want to reduce your risk. In a way, you are diversifying within equity by buying more stocks. If you avoid the IT sector and go with say, Pharma, you have done more diversification ! That is very essential to manage risk and return on investment you have made.

The other risk that you cannot help live with is in our system today – it is there everywhere and impacts everyone, not just you and worst of all, you cannot do much about it. For example, if the whole economy crashes, all your products, both the Infosys and the Pharma stock will be affected. Another example could be the monster called inflation, if will impact everything in the economy and not just one product.

So the point I am driving home is – there are some risks you just cannot manage. Stop worrying about them, start focusing on the ones that you can control !

Conclusion

So to recap :

1. Make sure that you diversify across investment classes.
2. Check whether when one avenue gives positive returns, the other gives negative.
3. Some risk can never be got rid of, stop fretting about them.
4. Risks specific to an asset class can be managed – spend some time here to successfully manage risk and return on investments !
5. Diversify across investment classes.
6. Within a specific class, diversify more !

Over to you now, how do you manage your risk and keep your portfolio balanced ?