How Understanding Risk Is Critical While Investing and Ways to Mitigate Risk in Investing

What Is Risk in Investment?

In general, risk refers to an adverse outcome than expected. We invest with an expected rate of return in a specified time period. Risk involves not achieving the expected return, i.e. achieving a lesser return than expected or incurring a loss. Risk also involves not achieving the expected return in a specified time period.

Based on an individual's risk tolerance, they may be categorised as an aggressive or conservative investor. A conservative investor will be averse to investing in equity mutual funds due to the higher risk involved.

Should Investors With Conservative Risk Profile Avoid Equities?

Equities are volatile and subject to corrections in the short term. However, over a period of time, the risk of losses gradually reduces and may even fall to zero after a specified time. For example, as per past data, the risk of negative returns in the Nifty 50 Index falls to 0% if the investment time horizon is eight years or higher.

So, should an investor with a conservative risk profile avoid investing in equity mutual funds for long-term financial goals? If they do that, they will be denying themselves an opportunity to earn inflation-beating high returns, accomplish financial goals faster, create wealth, and achieve financial freedom.

Hence, for long-term financial goals, investors should base their investment decisions on the investment time horizon rather than their risk profile. While equities do have risk in the short term, the risk can be reduced/mitigated in the long term.

Ways of Risk Mitigation

Some of the ways of mitigating risk include the following.

1)  Following the Financial Planning Process

1. Financial planning involves analysing an individual's finances and making a roadmap to achieve the financial goals. It usually involves the following steps:
2. Making a cash flow statement, networth statement and budgeting
3. Building and managing an emergency fund
4. Term insurance for family income earners, health insurance for the entire family, general insurance for assets like house, vehicle, etc.
5. Making a goal plan for financial goals like a child’s higher education and marriage, own and spouse’s retirement planning, investing towards goals, and regular review till the goals are achieved
6. While investing towards goals, ensuring the financial products chosen are tax-efficient
7. Nomination for all financial assets and having a succession plan in place

When you follow the comprehensive financial planning process, most risks get mitigated. For example, the emergency fund helps mitigate unexpected and unplanned financial emergencies. Term insurance as a risk mitigation measure provides financial backup to the family in the event of the earning member's untimely death. Similarly, health insurance shields you from hospitalisation expenses. Nomination and succession planning ensures a smooth transfer of financial assets to the intended beneficiaries on the owner's demise.

2) Focusing on Financial Goals Rather Than Chasing Returns

The financial planning process helps you focus on your financial goals and achieve them rather than chasing returns. If you are wondering how to select the best mutual funds, there aren't any that will give the best returns year after year. The best-performing funds keep changing every one to two years.

Investing in the last year’s top-performing funds is not the most appropriate way of selecting mutual funds. As long as your portfolio consistently delivers the expected rate of return required to achieve your goals, you need not be chasing top-performing funds.

3) Investing for the Long Term

You should always invest for the long-term investment horizon. In the long run, your money gets time to grow and benefit from the power of compounding. Take the guidance of a qualified and experienced financial advisor on how to build an investment portfolio  for the long term.

In the long run, your investments will go through multiple market cycles of boom and bust. The longer the investment horizon, the more the risk of negative or low returns gets reduced.

4) Regular Investments Through the SIP or STP Mode

Rather than making lumpsum investments, you should invest through the systematic investment plan (SIP) or systematic transfer plan (STP) route. Investing regularly using the SIP mode makes you a disciplined investor.

With SIP investments, when the market is going down and/or stays down for some time, you accumulate a higher number of MF units at a lower price. Later, when the market starts the recovery process and/or moves higher, the value of the units accumulated during the down phase increases, and your overall portfolio benefits.

If you make a lumpsum investment, and if the market falls sharply after that, you will be sitting on losses. However, an SIP gives you the benefit of Rupee Cost Averaging (RCA) in the long run.

Also, as your annual income increases, you can increase the monthly SIP amount using the step-up option. You can increase the SIP amount by an absolute amount or 5 to 10% every year. A step-up SIP will help you reach your financial goals faster than a regular SIP.

5) Keep Emotions Separate From Investments

The emotions of greed and fear are two of the biggest enemies of any investor. Some investors become greedy during bull markets and invest higher amounts. Similarly, some investors become fearful during bear markets and redeem instead of continuing their investments. Investment decisions driven by greed and fear are common herd mentality, which you should avoid.

In reality, it should be the opposite of the above. One of Warren Buffett's famous quotes says: "Be fearful when others are greedy, and be greedy when others are fearful." You should buy more when the markets are falling. It will benefit you when the markets complete the corrective phase and resume the uptrend.

Regular monthly SIP investments can keep you immune to the emotions of greed and fear.

6) Follow the FinEdge Dreams Into Action (DIA) Philosophy

You should follow FinEdge's 'Dreams into Action' investment philosophy, which involves creating a customised investment plan linked to an investor's financial goals. DiA is a collaborative software that facilitates investment best practices, conversations and joint decision-making to help you meet your goals as per your unique requirements. It involves the following five P's.

1. People: DiA brings investment experts and investors together, encourages customisation, collaboration and joint decision-making.
2.  Personalisation: It gives you hyper customisation, leading to investing success and a fantastic investing experience.
3. Purpose: When you invest with a purpose, you can disengage from excessive information clutter and deal with volatility better.
4. Process: Building discipline and perseverance through regular conversations and scenario analysis, managing investment behaviours.
5. Product: Aligning the right products to goals, deploying risk-reducing investment tools like SIP’s STP’s, Step-up SIP and regular goal reviews

Investing in Equity MFs: Proper Risk Mitigation Can Help You Achieve Financial Goals Faster

Equity mutual funds can be volatile, risky, and vulnerable to sharp falls in the short term. However, you should invest in equity mutual funds for long-term financial goals with an investment time horizon of five years or more. In the long run, you can apply several risk mitigation techniques and reduce the probability of negative or low returns. Thus, with the power of compounding, equity mutual funds can help you reach your financial goals faster and achieve financial freedom.