| Every investment has an attached risk
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'Just buy this blue-chip stock, there’s no risk at all.’ For
most people who invest in shares there is a good chance that you’ve heard
someone say this before. For most people who just put their money away in bonds
or deposits, one of your main reasons for this probably is -‘I don’t want to
take any risk at all, I just want my money safe.’
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Are these statements true? Is investing in bonds or deposits
completely risk-free? Or investing in blue-chip stocks necessarily very low
risk? NO.
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Whenever more than one outcome is possible from an
investment, there is always some amount of risk. Only the level of risk is
different.
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| Use risk to analyse expected returns
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While investing, risk is measured to evaluate the kind of
returns you should expect from the investment. Or your return expectations
should be based on the level of risk you can bear. In principle, the higher the
risk, the higher the returns that should be required.
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Empirically returns across various asset classes show that
investment in equity shares give the highest level of returns in the long-term,
followed by corporate bonds and deposits and lastly bank deposits and
government debt. Not surprisingly, the level of risk is also in the same order.
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You might be saying - how can debt be risky? It is.
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Companies that run into financial trouble could delay your
interest payments or even default on paying back your money. Even government
debt has some amount of risk. How? Simply put, governments like companies also
face the risk of financial problems. However, lack of funds for a company could
result in the company defaulting on a loan repayment. But a government can
always print more currency and repay its borrowings. So you will get your money
back. BUT, there is a hidden cost (risk). Printing more currency is likely to
lead to higher inflation and hence lower real returns on your investment (see
our article Running to Stand Still to understand about real returns).
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Agreed that the chances of governments or well-managed
companies getting into serious financial troubles are low. But that is only
difference in the level of risk. There is a risk attached, and that cannot be
questioned.
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| Understanding risk vs return essential for good financial
planning
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You might ask - why is it so important to understand the risk
versus return relationship? Because if you don’t, it is quite likely that your
investment returns will not match your risk profile and consequently you are
not managing your hard-earned money well. A wasted opportunity, as even a small
difference in your investment returns (at the same level of risk) can make a
BIG difference to your financial wealth (due to the astounding Power of
Compounding).
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To understand the importance of managing your money well read
Guide To Financial Planning. This article highlights why financial planning is
not as difficult as it sounds and how you can easily make your hard-earned
money work for you.
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Also you can use our Risk Analyser to understand your risk
profile (both your risk-taking capacity and your risk tolerance level) and read
The Need To Diversify to understand how you can increase your expected returns
while not increasing your level of risk.
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