Risk and Returns — Two sides of the same coin

Taking calculated risks on your investments goes a long way in wealth creation

A lot of popular cultural references like films and books tend to dramatize the role of risk in life. However its role in investing is undeniable. Taking calculated risks on your investments can go a long way in your wealth creation journey. In fact, investing only in “safe” products can actually prove to be extremely risky from a long-term perspective. Read on to find out more.

Are safe investment options really safe?

A lot of investors keep their investments in Savings accounts or in fixed deposits as they are seen as safe and give fixed returns. However, there is one risk involved in investing in these safe investments : Inflation Risk.

Here’s an easy example to understand Inflation Risk better: Let’s say 5 years back, you paid only ₹30 for a Masala Dosa but now you pay ₹45 for the same Masala Dosa. This means that in 5 years, the price of a Masala Dosa went up by more than 8% every year. This is Inflation or the increase in price over time.

To explain this using an investing analogy, let’s say you invested ₹30, 5 years ago in a very safe investment option that earned you a return of 6% per annum. Today it’s value is ₹40. While you did get a profit of ₹10, you are still ₹5 short. That’s inflation risk for your investment.

While every investor needs to make some investments in safe investment products, putting your entire investments in such products only would often lead to an erosion in the real value of invested money. For long term wealth creation, taking calculated risks is important or you may end up having less money in the future than you would need to meet your financial goals. Trying to achieve your long-term financial goals by investing only in “safe” products is almost like a batsman hoping to score a century without taking any risk involved in hitting a boundary or a six.

Let’s see how investors can benefit by allocating some money to high risk & high return investments.

Risk vs Return : Striking the right balance

Risk and Return often move in the same direction, i.e. higher the risk, higher the potential return but what is this risk that we keep talking about? The risk that we are talking about is the ups and downs in your investment based on market movements. Over the short term, these ups and downs can be more frequent but over a longer time frame, your investments have the potential to grow at a higher rate.

It is important to take calculated risks based on your risk tolerance, goals and the investment duration. Using these factors you can strike the right balance between risk and returns.

Here’s an example to understand how an investment with a higher return potential can help you accumulate wealth as compared to safer investment options:

Let’s say you start investing at the age of 25 and by the time you reach the age of 50, you want to accumulate wealth of 1 Crore. You can approach this goal in many ways: For example: You can invest in safe investment options that offer a return of say 6% or you can go with equity mutual funds having higher return potential of say 12% (it comes with short term ups and downs). Here’s how much you will have to invest every month in both cases:

Observations:

• This shows that if you only invest in safe investment options earning a return of 6% p.a., you will have to invest ₹15,000 every month to accumulate ₹1 Crore by the age of 50.
• If you invest in Equity Mutual Funds and earn a return of 12% p.a., you need to invest only ₹6,000 every month to reach your goal of ₹1 crore. This is significantly lesser than what you need to put aside in a safe investment option to achieve your goal.

Now that you know how taking some risk in your investments will help you in the long run, here are a few things you can do to ensure that you stay the course with your investments:

• Stay invested for the long term — Over long periods of time, investments with some risk exposures such as equity funds tend to give better returns than completely safe investment options. Hence, the longer you stay invested the better.
• Consistency is important — Keep investing regularly via monthly SIPs as it is not just a convenient way to accumulate wealth over time but also help reduce the risk of short term market ups and downs.
• Diversify your investments — You can also align your investment to your risk comfort by spreading your investments across various types of funds, viz. Equity funds, debt funds. Read more about it here.

Don’t shy away from taking measured investment risks as they will help you grow your wealth in the long term.

Mutual Funds are subject to market risk. Please read all scheme-related documents carefully before investing.

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