Importance Of Risk Management

In the investing journey, the first question that investors ask is, “What will be the return?” Another often repeated question is: Is the return safe and guaranteed? The follow-up question is: “Will the return be more than that of bank fixed deposits and also be safe?” Look at the questions that many of us pose as investors! It is all about return and that too guaranteed. What about risk? Risk comes into consideration only when the returns evaporate, doesn’t it ?

Risks in investing

The question we should be asking is: What is the element of risk involved for getting the return we are expecting? Is it too much to ask for when it is our money that we are investing?

Let us understand what is the risk we all are talking about. Risk in simple terms is about probability/ possibility of a loss/harm or danger, which is uncertain. In investing, it can translate into negative return, loss of capital invested or deferment in receipt of interest, etc. This is the elementary part when we talk about risk. What is risk management, which is paramount when it comes to investing?

Risk management

Risk management is about identifying the risks in advance (which is unique to each individual) and after analysing, having to mitigate the rank (and thereby enhance the predictive return). Within an individual or an organisation, the risks can be further categorised based on: Risk capacity—(ability to take risks without jeopardy to the goals);

Risk appetite —(amount or type of risk you are willing to take in pursuit of objectives);

Risk tolerance—(acceptance of outcome of risk)

What it means is to build a plan based on one’s values, goal and financial situation, unique to each individual. Getting this framework of risk (capacity, appetite and tolerance) in order is important in the risk management framework. For the last few months, investors have noticed their portfolio corpus going down. This is where the risk management approach comes into play, which together with asset allocation method, ensures that the sentiments are factored in, before the investment journey.

Understanding risks

An illustration can help us understand the concept of risk management in a more effective manner. As an investor, you have a disposable corpus of Rs 1 lakh a month to invest. And you have the goal to reach a wealth of Rs 1 crore in five years. So you are expecting an annualised return close to 21%, which is high (risk capacity). However, the outcome of taking this risk may mean that instead of the target goal of `1 crore, the corpus can also become `50 lakh, which in this case means erosion of the capital (risk tolerance). Are you ready for this? Accordingly, you will then decide whether you have the stomach for this kind of a scenario, which is what risk appetite is all about?

If you have had considered these three elements of risk management in framing your investing process, the current downturn in the portfolio would not cause pain. But then, learning about investing is a lifelong process. That is why you need a risk management framework in the investing process to ensure that emotions do not create havoc in the investing journey.