Why Is It Important To Manage Risk?

The traditional opinion in the investment world is “higher the risk higher the return,”. It is widely believed that investors are rewarded for taking on more risk by way of higher returns. However, this is not always true. A more accurate way of presenting the risk-return relationship would be to say, “higher the risk higher the potential return.” It is important to understand that as we go higher on the risk spectrum, not just the potential return but potential loss increase too. Managing risk becomes an integral part of optimal investment decision making, one that requires an individual to assess his/her own risk profile along with the relative risk of the investment instrument. When you choose to invest your money in riskier assets than a standard savings account or fixed deposit in banks, you are likely to experience any or all of the following to some degree.

Loss of principal: In investment parlance, risk is simply the probability of loss. The biggest fear that investors face while making investment decisions is the fear of loss of capital. Thus, when you choose to invest in riskier assets, do not just get swayed by potential returns. Instead. Look at risk adjusted returns, which measure the risk taken to generate a unit of return.

Not keeping pace with inflation: The main aim of investing your money is to ensure that it can grow to a value that can help you achieve your future goals. Now, over a period of time, the general prices of goods and services increase due to the impact of inflation. There is always a risk that your investments could rise in value slower than prices like inflation. However, this is more likely to happen if you invest in low-risk or risk-free instruments as the potential returns generated from these instruments are relatively low. 

Not having sufficient funds: In addition to the impact of inflation, there is always a probability that your investments will not generate the expected returns and will consequently leave you short of funds when you need them. The fear of coming up short can often induce investors to assume higher risk than they should.

While there might be several ways to mitigate each type of risk, the optimal way to reduce portfolio risk is to build a diversified portfolio that is spread across asset classes such that it is well aligned with your risk-return requirements.