Page 56 - DMGT515_PERSONAL_FINANCIAL_PLANNING

Unit 3: Managing Investment Risks

worth taking? There are three basic steps to assessing risk: Notes
Understanding the risk posed by certain categories of investments
Determining the kind of risk you are comfortable taking
Evaluating specific investments

You can follow this path on your own or with the help of one or more investment professionals,
including stockbrokers, registered investment advisers, and financial planners with expertise in
these areas.

Step 1: Determining the Risk of an Asset Class

The first step in assessing investment risk is to understand the types of risk a particular category
or group of investments—called an asset class—might expose you to. For example, stock, bonds,
and cash are considered separate asset classes because each of them puts your money to work in
different ways. As a result, each asset class poses particular risks that may not be characteristic of
the other classes. If you understand what those risks are, you can generally take steps to offset
those risks.

Stock Investment-wise Risk Levels

Now that we have discussed risk from the perspective of the investor, let us look at investment
risk. This is necessary because different investments carry different levels of risk.

Equities and Mutual Funds

Equities and related investments, such as mutual funds, carry a high level of risk. More
importantly, they help you beat inflation and create wealth.
The risk in equities is significantly higher in the short term, when the value of your portfolio
depends completely upon the whims of the capital market.
The only way you can avoid this risk completely is by avoiding investing in equities. Hence,
investing in equities is essentially an exercise in risk management and risk reduction to a certain
extent rather than risk avoidance. Financial products like mutual funds and derivatives are
aimed at exactly that.

Debt Instruments

This class of investments includes relatively low risk instruments such as government bonds,
money market funds, bank fixed deposits, liquid or gilt funds, and so on.
However, seldom are phenomenal results expected from these investments; in fact, many debt
instruments offer a fixed rate of return, which often fails to outrun inflation.

Asset Allocation

Creating an optimal investment mix, bearing in mind risk profile and return objectives, is what
asset allocation is all about.

When done properly, asset allocation ensures that a portfolio diversifies or spreads the overall
risk across investments. A balanced portfolio should include a mix of equities, debt investments,
commodities (such as gold), and real estate. How much capital you invest in each investment
class depends upon your risk profile.

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