Thursday, January 1, 2009

Investment planning: Understanding Investment Risk involved in financial planning

Risk in investment planning is not only that the chance that the person may lose his capital but more importantly a chance that the investor may not also get the desired return on investment product.
The investment products are
1. Fixed income instruments
2. Market oriented investments
There is always a risk/return trade-off. The greater risk taken the greater must be the potential return as reward for committing funds.

Risk Avoidance
If we know that eating outside food is not healthy so there is a risk that we may fall ill but if we dont eat outside completely we are avoiding the risk totally. If we dont invest in equities we are completely avoiding the risk of market downturn. but sometimes not investing in equities can be risk because of value of money reducing via inflation.

Risk Transfer
This is a better way to handle risk then risk avoidance. an easy example to understand risk transfer is concept of insurance. We have a chance of getting ill and getting hospitalised and exposed to the risk of high medical bills. we can transfer the risk of high medical bills to an health insurance company by taking a health cover for some fee called premium. There are many such examples in investing of risk transfer.

Influence of time on Risk
Investors need to think about time period in there investment plans. In case of an individual it may be planning for retirement, or down payment of home purchase or marriage on the cards. The longer the time horizon the more risk can be incorporated into financial planning.

Generally it is well established that equities as an asset class has outperformed all other asset classes and delivered superior returns over longer periods of time. with this statistics available, why wouldnt everybody invest 100 percent in stocks ? The fact is while over a longer term period stocks have outperformed but there have been may short term periods in which they have underperformed and infact had negative returns. Thus if you have long term then your risk is less but if you have short term horizon then your risk is high in holding stocks. Financial planner has to take into account the time horizon while structuring investment portfolios and the general rule is younger the person the longer is the time horizon and hence more exposure to equities.

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