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Understanding risk – I

by Ramaswamy P
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Risk is part and parcel of life. Whether we like it or not, we need to face it and live with it. Be it walking along the road, driving a vehicle, cooking every day, living in a contagious situation or even sleeping at night – everything comes with its own risk. There is no way you can run away from any of these day to day activities. All that we can do is learn to manage these risks and reduce the instances of undesirable consequences. The first step to managing risk is to first recognise various risks that are associated with these activities.

While the dictionary meaning of ‘risk’ is ‘danger’, the degree of risk can vary across investments and hence its impact on our portfolio too. But the risk is the risk – be it big or small. It is time we understand them and make informed investment decisions:

Bank deposits

It is the most popular investment option among Indians since it is perceived to be safe. While many assume bank FDs to be 100% safe, as per RBI guidelines, deposits only up to Rs.5 lakh are insured under Deposit Insurance and Credit Guarantee Corporation (DICGC). In case there is a crisis in the bank, deposits beyond Rs. 5 lakh are at real risk. This is called CAPITAL RISK.

Some investors are smart. They make deposits in different banks. No doubt that is a good strategy. But another risk crops up: INFLATION RISK. If the banks offer an interest rate of 6.5% and real inflation is at 8%, then your real return is indeed (-1.5%). An FD of Rs.5 lakh at 6.5% at the end of five years would have grown to Rs.6.85 lakh. But inflation of 8% would result in Rs.7.34 lakh, which means what you bought for Rs 5 lakh five years back would now cost you Rs.7.34 lakh. Since your FD grew to Rs.6.85 lakh, you lose your purchasing power by Rs.49000.

Above all, there is REINVESTMENT RISK. A retired person could have made a deposit for five years and planned his cash flow. But if the FD rates fall after five years, and inflation has gone up by that time – then it is a double whammy for him and he/she runs the risk of reinvesting at lower rates.

Life insurance

India is one of the few countries where insurance is being ‘SOLD’ as an Investment product, while, in reality, it is a compensation product. Just like in vehicle insurance, true life insurance compensates for the damage. While many may accept the concept of term insurance which is akin to vehicle insurance, in real life many expect a return of at least the premiums paid – if possible with some returns. That opened the flood gates of a variety of endowment policies and market-linked policies which often deliver a paltry return of 3% to 5% – resulting in INFLATION RISK of around 3% to 4% per annum.

Real estate

This is the most sought after investment option for Indians. About 57% of household assets are in real estate. While many of us invest in real estate for the sake of appreciation, we rarely realise it in our lifetime. Even if we wish to sell some, the time taken to negotiate and liquidate the same is enormous – not to mention the nitty-gritty of payment schedules involved in it. Hence if you are unable to sell your asset immediately, then you run into LIQUIDITY RISK.

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