Gauge The Risk-Return Of Investments

With investments, we tend to only ask about the expected returns without understanding the risk factor and sustainability involved. The returns push and greed can result in losses in poorly-researched high interest-bearing instruments and alternative investments. Aggressive selling can also often result in customers not being made fully aware of the risk involved. Here are some questions you must ask before investing in any financial product:

Is it regulated? Products that are regulated and protect investors’ interest are preferable. An efficient system that develops strong policies fosters innovation, addresses investors’ concerns and ensures stability of the financial ecosystem. Many of the new alternative products do not have a mature and well-developed regulatory system yet.

Is someone giving the underlying return promise? Financial instruments guaranteed by the government are considered the safest, since they offer capital protection. Getting a high-return product from a private company has only so much value since there could be forces that hit the long-term sustainability of such a company. Fixed-return products guaranteed by the government can, however, form only some part of your portfolio since they may not be able to keep up with inflation.

What is the investment tenure and returns predictability? Investors need to determine their short- and long-term goals and align them with appropriate asset allocation. Look at the investment returns of the product over a longer term like five and 10 years to understand the sustainability and predictability of returns, instead of getting swayed by a recent good run.

Let’s look at some asset classes and their return predictability ranges that are suitable for a broad set of investors. We have taken Nifty 50 TRI Index and one of the top liquid funds, HDFC Liquid Fund, (see graphic) as examples of asset class benchmark in equity and debt, respectively. They have performed very differently but as the time horizon increases, the minimum and maximum returns tend to move away from negative territory, thereby, reducing the possibility of capital loss. The standard deviation, which measures risk, tends to reduce as time horizon goes up.

It’s critical to understand one’s emotions for money. Your risk profile will also be an evaluation of your willingness and ability to take risk.

Varun Girilal is Co-founder, Scripbox