Wealth Building: How to balance risk and return for optimal growth?

We understand return better than risk. Return is the money we get when we invest in an asset or put money in a deposit or lend money on interest and so on. It’s simple to understand that if you are investing or lending or opening a deposit to park your money, there should be some compensation that comes your way, else it would make more sense to just spend it.

Have you ever thought about how this return is determined? Every investment does not give you the same return, neither does every deposit promise the same interest rate. Even in real estate, we know anecdotally that rentals differ based on the city, the micro locality and within that the complex or gated community and within that, the condition of the individual flat or house that you are looking to rent.

To put it simply, returns from all investments are determined by attributes of the asset. Then the return is either market determined, based on demand and supply or it’s pre-set by the issuer like a bank with deposits or a corporate issuing bonds with fixed coupons. It’s also known that higher the risk in an asset, could be short term volatility or risk of uncertain earnings or a credit or quality related risk, higher the return you will seek from it. The more certain the pay-out from an asset is the more likely you are to settle for a relatively lower return.

While the return discussion is more popular and easier to comprehend, it’s less critical than the discussion on risk. Moreover, the risk of the underlying investment product is just one aspect, you need a deeper understanding of how much risk you can take based on your unique circumstances and behaviour.

Adjusting risk as per circumstance

Let’s say you want to save up and invest such that you are able to afford the down payment for a house you would like to buy for two years on. If we go by the theoretical risk matrix, we know that stable return investments like bonds, deposits and debt mutual funds are perhaps a better choice. This is because your goal is not too far and the amount you need is known and more or less non-negotiable.

However, you may realise that the return itself is not enough for the corpus you want to build. Thus, you consider blending in some calculated risk. This could be equity shares of large cap companies which have the potential to deliver relatively higher returns as compared to the stable return investments or even an equity index fund.

This ability to take on equity risk for a brief period of say two years must also be backed by the existing cushion of an emergency fund, some accumulated assets like another house property or an existing portfolio of equity shares or mutual funds. If you have some of the above and the value is something that is substantial enough to kick in, in the worst case scenario where your equity returns plummet by the time you need it, then the risk could be justified, despite the short term and certain nature of your requirement.

The opposite turn of events can also take place. Let’s say you are looking to invest long term money in a fixed deposit like return or maybe park in a ten year government security or debt fund with the intention of being invested for 8-10 years.

On the face of it, long term investments of 8-10 years benefit more from growth assets that help in creating wealth. If you can leave money invested for so long, why not choose assets where returns tend to beat inflation in the long run, thus, growing wealth.

However, if someone already has large wealth and is considering wealth preservation for future generations as the financial objective, investing long term money in stable return assets is the need of the hour, rather than taking more risk.

Thus, the unique circumstance of the financial objective at play should define the risk you take. Diversify as per your need rather than purely on the basis of the nature of risk carried by the asset you invest in.

Absorbing behaviour risk

Another secondary aspect of risk is how you tend to behave when certain events occur. Theoretically, we know that equity markets can correct 10%-20%-50% in one stretch of correction. Knowing this, you may think you are prepared for it.

However, when you visually see the value of your investment become half of what it was in a matter of months, fear can take over. Panic sets in and dictates behaviour. This very easily can lead to you withdrawing all your equity investments and vowing never to enter the markets again.

Then you will stop tracking and you will not be able to see how the recovery takes place, had you remained invested.

At market peaks, the opposite of panic happens; in euphoria, many jump in to over allocate towards equity assets without understanding how much risk is building up in their portfolio. Every excess return at that point seems plausible, even if it’s too good to be true. Then if the market cracks you lose more than you expected because you are over allocated.

Absorbing your behaviour and the risk of unreasonable action is important. What that means is that you should be able to step back and objectively analyse what you are doing and whether it’s because of greed or fear or a purposeful financial allocation of funds. If you are unable to absorb your own behaviour and you are too quick to react, the return outcomes are unlikely to be what you initially desired.

Return is what we seek from an investment. Ultimately the return from your investment decisions is a function of not just the asset risk, but also the amount of risk you are willing to take given your circumstances and also the risk you can absorb. All three are important for the decision to yield the desired return.

Lisa Pallavi Barbora is a financial coach and founder of moneypuzzle.in