INVESTING 101: Risk and Reward: Finding Your Balance
One of the biggest lessons you can learn from investing is risk management. You might have often heard the phrase: “Taking calculated risks can lead to unimaginable results!” But, it doesn’t mean that you should take risks just for the sake of it. Doing so can go very badly.
Risk management in investing is all about finding balance. According to your future plans, the amount of money needed and the time in which you need it are key factors in finding that balance. Therefore, you should never invest your money somewhere on a whim. Instead, find particular instruments for your investments which will match your goals.
A good way to find this balance is through your age. Consider the rule of 100. According to this rule, subtract your age from 100 and the result you get is the percentage of your portfolio that you should invest in equity. So, for instance, let’s say your age is 18, therefore (100 - 18 = 82) which means you should keep 82% of your total portfolio amount in equity, and rest of the amount in other instruments, i.e. 10% in gold (in order to diversify and reduce volatility of your portfolio), and rest of the percentage (i.e. 8% in this case) in other places such as bonds, crypto, REITS (Real Estate Investment Trust), etc.
This rule emphasizes investing the major percentage in equity because equity is the instrument that has the potential to provide exponential returns. At the same time, it is a higher risk which is why this rule states to invest more in equity, while you are young.
Extending further, let us discuss two more risks to keep in mind before investing you hard-earned money.
#1 Liquidity Risk:
Before investing, you need to know how easy it is to liquidate the asset when the money is needed. In case, you know that you’ll need money after 1-2 years, then you won’t invest in an asset class which has low liquidity, and if you do so, then you won’t be able to recover your money back short term. For example, when a person knows that they’ll need money after 1 year, then they should not invest in real estate since real estate investments are long term. Instead, they should go for something low risk with high liquidity like Mutual Funds, ETFs or Bonds.
#2 Inflation Risk:
This risk is associated with the rate of return that a particular asset class provides. If an asset class provides a return with a rate equal to, less than, or near the current inflation rate, you could lose your money instead of make any returns. If we assume that the inflation rate is 6%, and your returns are 6% as well, then actually you are making 0% returns. If your returns are less than 6%, then you’ll be making negative returns. In the last case, where your returns are more than 6% but still near to 6% (i.e. like 7-8%), taxes will claim whatever returns you do get. Therefore, before investing your money anywhere, make sure that you make at least 4% more than the present inflation rate.
