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Striking the Right Balance Between Risk & Return
While no investment is without risk, to build a corpus over time, you need to accept a certain amount of risk. Higher the risk you take, the higher the potential return. So, how can you strike a balance between your risk taking capacity and desire for higher returns?
Let’s say you have an option to invest in equity funds A and B. While both A and B give an average annual return of 15% over a three year period, fund A has much more volatility as compared to fund B. Which one would you choose? It is a no brainer that you would prefer fund B since it is less volatile and hence less risky, whilst offering you the same returns. It is not advisable to take on unnecessary risk for the same amount of returns.
When it comes to striking a balance between risk and return in your investments, there is no set formula that can be used. The balance depends on the risk and volatility involved, your appetite for risk and your investment goals. Let us look at each of these factors:
Measuring the risk and volatility involved
One might use tools and ratios such as Alpha, Beta, Sharpe ratios, Standard deviation or use qualitative analysis to calculate the risk and volatility of various investments. These will not only give you a better understanding of risk and volatility, but also help you choose a fund over others. Having done this, you can choose an investment that maximises your returns with the level of risk you are comfortable with.
Knowing your risk appetite
Finding out if you have a low, medium or high risk tolerance will enable you to identify the next steps for choosing the right investment with the risk you are comfortable with.
Three Steps to the Right Balance between Risk and Return
The key is to strike a balance by taking a calculated risk with the following three steps:
Diversifying your portfolio.
Diversification has many advantages, the key one being reduced risk while retaining the possibility of higher potential returns. By increasing your exposure to diversified investments, you will be essentially spreading your risk. However, one should be careful of over diversification as it can do more harm than good.
Reviewing your investments.
It is important to review your investments from time to time. You should also evaluate your risk tolerance periodically, as it may change with different life stages. A periodic check if your investment portfolio is in line with your risk tolerance and return requirements will enable you to maintain your risk and return balance.
Staying invested for the long-term.
This will minimise most risks as it will give enough time for your investments to generate returns. You can afford to take higher risks as your investments will have more time to recover from market fluctuations. Starting early and investing regularly, even if in small amounts, helps rupee cost averaging to work, helping you buy more when the market dips, leading to higher returns.
There will be times when your investment values will fluctuate, no matter how ‘safe’ it may seem. Balancing your risk and return expectations will make the ride much smoother and ensure that you are not taking on unnecessary risk that can lead to a big loss. It will also ensure that your investments generate higher potential returns to meet your financial goals.
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Look at a mix of all asset classes when looking at diversification for balancing risk and return.
If you are unsure, you can always start with low risk investments and keep adding high risk investments, as you gain experience.
Make sure that you do not spread yourself too thin, making it difficult to manage your portfolio.
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