Understand risks to get rewarded in the long run

Risk is an inherent part of our investment process. While there are attendant risks of investing in market-linked options, there are also risks that emanate from either not following the right strategy or not choosing the right asset classes or lack of knowledge. Some of these are longevity risk, inflation risk, liquidity risk, and behavioral risk. 

While risk is a possibility that a negative financial outcome may occur, knowing these risks and having a strategy in place to tackle them ensures that you don't compromise your financial future. Since we are at the start of a new year, let's understand more about these risks and analyze the need to make changes in the portfolio to improve performance of the portfolio. 

Market risk - Market risk is the risk of varying degree of volatility from time to time. In fact, this is the main risk that keeps investors away from the stock market as well as market-linked debt and hybrid products offered by mutual funds. In reality, if one can handle this volatility well, returns can be far better than traditional options. Fortunately, there are strategies to tackle the risk of volatility, that is, diversification, disciplined approach and rebalancing the portfolio. 

While diversification helps in managing the impact of market risk on the portfolio, a disciplined approach allows you to save and invest on a regular basis. Rebalancing the portfolio ensures that you remain invested in different asset classes at time in a proportion that suits your risk profile. 

Longevity risk - Longevity risk is basically a possibility that one might outlive one's assets. This risk is often faced by those who either fail to build a corpus large enough that can ensure a dream retirement or by those who invest very conservatively after retirement. 

Hence, the focus should be on building a portfolio wherein market-linked products offered by mutual funds play a significant role in both accumulation and disbursal phase. These have the potential to provide higher post-tax returns. 

Inflation risk - Inflation is crucial to investing as it reduces the value of your investment returns. Therefore, to ensure that your portfolio grows in value and not just in numbers, you must consider aim to earn positive real rate or return. 

The strategy to tackle inflation is to include an asset class like equity that has the potential to beat inflation for long-term and invest in tax efficient investment options in debt and hybrid funds for short and medium term. 

Liquidity risk - Liquidity risk is the risk of not able to access your investment at a time when it might be required for a sudden need. At times, to sell an investment, you may need to accept a lower price. In some cases, it may not be possible to sell the investment at all before maturity. While most traditional options have a lock-in period and exit is possible by paying a penalty, there are options like non-covertible debentures where at time liquidity and the market price can be an issue. 

Considering that liquidity is an important aspect of your portfolio, open-ended MFs can be an ideal solution. These funds allow you to exit anytime at Net Asset Value that reflects the true current value of your investment as holdings in the funds are marked to market on a daily basis. 

Behavioral risk - While we all know that uncertainty is an integral part of investing, not many of us tackle such tricky situation in a proper manner. It is common to see investors making ad hoc decisions when faced with certain market conditions, as well as refusing to exit from an option at a loss despite its continuing poor track record. To keep emotions out of your investment process, stick to your investment plan irrespective of the market condition. 

The writer is CEO, Wiseinvest Advisors