Understanding Risk

Personal finance is everything to do with managing your money and saving and investing. We are sharing a series of articles where we shall discuss 9 useful personal finance concepts which everyone should know and learn.

In this first part, we shall understand Risk.

Risk, the word itself creates a sense of fear in the mind. We all want to avoid risk, but unfortunately, we cannot. Risk is everywhere. We cannot avoid it and that’s why we must understand the risk and learn the ways to manage it. Being cautious and taking necessary steps to manage risk is better than living in avoidance behavior.

Inflation Risk:

All investment products carry risk, even Fixed return products carry risk. Risk of getting a negative real return.

Real Return = Nominal return – Inflation

In the real world, inflation is much higher than the data published by govt agencies. In personal finance, the definition of inflation should be, a rate at which your expenses are growing yearly due to price rise and changes in lifestyle. With the increase in lifestyle expenses and constantly decreasing interest rates, fixed return products hardly can give any real return after adjusting the effect of inflation.

Market Risk:

Definition of market risk is ‘Risk of losing money due to market correction or due to falling prices of security bought in the portfolio.”

In the case of equity as an asset class market risk is less in longer-term compared to the short period. The probability of Sensex or Nifty going down is more in 1 year compared to 5 years. And it is lower in 10 years compared to 5 years.

Managing Risk:

To manage risk in your portfolio you need to adequately diversify your investments in equity and debt.

Your short-term investments should be more towards the fixed income category as the risk of inflation will not harm the value of the portfolio much in short term. The risk of inflation is much higher in the long term as its compounding effect can erode the purchasing power of your money considerably in long term.

Your long-term investment should be more towards equity as the market risk is lesser in long term compared to the short term. In long term, equity can give you a much better return compared to debt and save your portfolio from inflation risk.

Remember, He who is not courageous enough to take risks will accomplish nothing in life.

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