High-Risk High-Return – What is the catch?
An investor would often come across distributors, bankers, advisers, wealth managers and various websites harping upon the commonly used phrase in investment “high risk, high return” but these so-called advisers fail to harp upon the fact that risk is guaranteed but not the return.
Through this article, we will try to understand that why the return is not always directly proportional to the risk taken.
Let us understand this with an example – There is a race where one has to go from point A to point B which passes through various terrains like plains, hills, tough roads and has a total distance of 3000km which can be easily covered at an average speed of 40km/hr in 7.5 hours and the person who reaches the point B wins.
There are two bikers Mr. Slow and Steady and Mr. Fast and Furious.
Mr slow and steady drove at the speed of 40km/hr and in the past 10 races has finished the race 10 times whereas Mr. Fast and Furious drives at the average speed of 75Km/hr but he has only completed the race 4 times, as many times due to the increased speed he had met an accident and not been able to finish the race.
The point to note here is Mr slow and steady has a higher probability of finishing the race whereas Mr fast and furious if finishes, can reach early but his probability to finish the journey is 40%.
The same analogy can be applied in the investment as well.
Investments are more like a long-term race that could last for many years depending upon the goals of the investor.
For some goals like buying a car it might be for 3-5 years, children’s marriage for 10-15 years or retirement 20-30 years hence it’s important to finish the race i.e. achieve the goal.
One has to understand the phrase “high risk, high returns”, which often understood that if an investor takes a higher risk that would translate into higher returns but as a prudent investor one has to understand that RISK is guaranteed but RETURN is not guaranteed.
Yes, taking high risk enables an investor to reach the goal faster but it does not guarantee that it will be achieved.
Hence it is very important to understand the risks and be aware of the goals and the ability to take the risk and requirement of risk for that particular goal.
Thus it is very imperative to align your investment with the risk profile. Understand the risk-reward for a particular investment.
Map the investments with the goals, be it long-term or short-term.
Understand that it’s not always about taking the higher risk but also equally important is to constantly keep on investing and participate in the market.
Spending time is very important for the equity as an asset class as the market rewards for the risk and the patience to keep invested in the market.
This is the very reason that while deciding upon which investment avenues to chose from, it is very important to quantify one’s risk profile.
Having a fair understanding of one’s risk-taking ability and then understand the risk of the portfolio that one is constructing as well and subsequently deciding on the risk of the products so that one can achieve the right mix of one’s own risk with product’s risk.
Things are all good when markets are going great, everything is positive in the environment and people are talking about investments everywhere.
It’s easy to ride the bull but very risky to come near to the bear.
So, what happens if you don’t match the risk – you are bound to meet an accident.
Let’s look at these three case studies –
Case 1 – Age 20 (Young) –
In this case, there is no savings but the investor is having an investible surplus of 10,000 per month at his disposal which he is advised to invest in Fixed Deposit as they are the safer investment instruments.
Though his goals are long term e.g. retirement is after 35 years and even the second goal is 10 years old but by keeping the investible surplus entirely in Fixed Deposits the investor is running a risk of not meeting the goal hence he might consider diversification into various asset classes which could be debt or equity.
Case 2 – Age 40 (Middle-Aged) –
In this case, we can see that the investor is having 20 lakh as current savings and an investible surplus of 30,000 per month at his disposal which he is advised to invest in Equity Mutual Fund/ULIP and SIP simultaneously.
Goal 1 (Retirement) is long term with a horizon of 20 years and instead of diverting his savings in Lump sum towards this goal the investor can well deploy the SIP and the other Goals which are short term can be funded by Lump Sum investments.
But this investor should avoid investing in Equity as an asset class since Equity can be highly volatile and might even result in nonachievement of the Goal when the money is required rather it can be invested in Debt mutual funds which are safer options as compared to Equity.
Case 3 – Age 60 (Retired) –
In this case, we can see that the investor is having 90 lakh as current savings and does not have any investible surplus per month since he is retired and does not have any income.
He is advised to invest in Equity Mutual Fund which can give him a high return and can also bring higher volatility to the portfolio and since his goal is to have a regular income post-retirement, investing in an equity mutual fund can jeopardize the regular inflow required.
These case studies depict the mismatch between the Risk profile of investors, goals identified, risks involved in the investment alternatives, cash flow required, etc.
Understanding the risk of an investor is very important but equally important is making sure that the risk of products is understood as well and the mapping of both the risk is very important while constructing the portfolio.
For example, an investor who is risk-averse (not willing to take any risk), his risk score can be considered as 1 (5 being very aggressive) if he is investing in let’s say fixed deposit or RBI bonds (risk-free instruments) then it’s in line with his risk score.
But if he is exposing himself too much in equity as an asset class and is investing in mid-cap or small-cap funds (rated 4-5 in the product risk category) then he is deviating too much from his risk profile.
A prudent investor has a better understanding of the risk and is not carried away by a high-performing market neither is he/she panicked when the markets crash, rather he sees the opportunity under such circumstances.