Understanding Investment Risk and Asset Diversification

Yes, you can also lose money if you invest your savings unplanned or without understanding the risks of investing in different products.

There are four primary asset classes that most individuals can invest their money in:

1. Equity - This also refers to stocks traded in the stock market.

2. Debt refers to products like Fixed Deposits, Government bonds, the Public Provident Fund (PPF), and National Savings Certificates (NSCs).

3. Real Estate - Residential and commercial property or land.

4. Commodities - Stuff like Gold, Silver, etc.

In financial terms, an asset's risk is defined as the volatility in its price.

This means that if you buy a high-risk product, the probability of its price going up (or down) in the short term is high.

Similarly, if you buy a low-risk product, its price will probably not fluctuate much (either up or down in the short term).

Let's understand this with practical examples:

High Risk/High Volatility Asset (Equity): 

Akshay invested ₹1 lac in shares of a technology company. Over the next six months, the stock price experienced these changes:

• Month 1: Rose to ₹1.15 lacs (+15%)

• Month 2: Fell to ₹95,000 (-17.4%)

• Month 3: Fell to ₹82,000 (-13.7%)

• Month 4: Rose to ₹1.05 lacs (+28%)

• Month 5: Rose to ₹1.20 lacs (+14.3%)

• Month 6: Fell to ₹1.08 lacs (-10%)

Despite the wild swings, Akshay's investment grew by 8% over 6 months, but the journey was a rollercoaster.

Low Risk/Low Volatility Asset (Fixed Deposit): 

Maya invested ₹1 lac in a fixed deposit offering 7% annual interest. Her investment growth was steady and predictable:

• Month 1: ₹1,00,583

• Month 2: ₹1,01,167

• Month 3: ₹1,01,750

• Month 4: ₹1,02,333

• Month 5: ₹1,02,917

• Month 6: ₹1,03,500

Maya's investment grew by only 3.5% over 6 months, but there was zero volatility or risk of losing the principal.

EQUITY

This is a high-risk / high-growth asset class. Your money can grow significantly, but it can also lose value significantly. Over the last twenty years, these products have given average annual returns of around 12% to 15% per annum.

For example, if you had invested ₹1 lac in a good-quality equity mutual fund in 2000, it would be worth approximately ₹18-20 lac today (2023). However, during this period, there were years like 2008 when the value might have temporarily dropped by 50%.

DEBT 

These are low-risk and low-return products. Your FDs or PPF give you an assured annual return. Over the last couple of years, they have returned 7 to 9% p.a.

For example, ₹1 lac invested in PPF in 2000 would be worth approximately ₹4-5 lac today. There would have been no drops in value along the way.

REAL ESTATE

Again, these high-risk products give high returns over the long term. They are also illiquid because selling real estate quickly is difficult if you need money urgently.

Consider Sanjay, who bought an apartment in suburban Mumbai in 2005 for ₹30 lacs. Today, it's worth ₹1.2 crores - a 300% increase. However, when he needed money urgently in 2009, he couldn't sell it quickly even at a 20% discount because there were no buyers during the global financial crisis.

GOLD

The rise or fall in gold prices is based on demand and supply in the international market, and its prices can sometimes be volatile.

Rekha's family has been buying gold every year during Diwali. They purchased gold worth ₹50,000 in 2010 when gold was around ₹18,000 per 10 grams. By 2012, it had risen to ₹32,000 per 10 grams, making their investment worth ₹89,000. But by 2015, it had fallen to ₹25,000 per 10 grams, reducing their investment value to ₹69,000. Today, it's worth approximately ₹1.3 lacs.

To better understand the risk of losing money, you need to understand the difference between a 'paper loss' and a 'real loss'.

Let's say you have ₹ 1 lac today, which you want to grow aggressively and decide to invest in stocks (also known as shares) via the stock market.

You identify a good company 'X' whose share price is currently ₹100 and buy 1000 shares for ₹1 lac.

The price of the share will increase to ₹ 120 in two months. You will be very happy, as your investment has grown to ₹1.2 lacs.

You have made a profit of ₹ 20,000. However, this profit is on paper only, and you will not have a real profit until you sell your shares.

Suppose you decide to hold on to the shares, assuming the price will increase.

However, 1 month later, the share price falls to ₹110.

Your investment is now worth ₹1.1 lacs, and compared to 1 month earlier, you now have a paper loss of ₹ 10,000.

After another month, the stock price falls to ₹ 90. Your new paper loss is ₹ 20,000 compared to the previous month.

However, if you look at the total scenario, four months ago, you bought 1000 shares at ₹1 lac. They are now worth ₹ 90,000, so your net loss is only ₹10,000.

However, this is still on paper as the number of shares you own is still 1000. Your loss will become real if you sell those shares now at ₹90.

If you continue to hold them longer, the price might increase to ₹ 150 or 200, and you will again make a profit.

Vikram's experience perfectly illustrates this concept:

Vikram invested ₹ two lacs in shares of a reputable bank in January. By March, the share price had increased by 20%, making his investment worth ₹2.4 lacs. Excited by the quick gain, he was tempted to sell but decided to hold on, hoping for more growth.

In April, global economic news caused the banking sector to fall, and his investment dropped to ₹2.1 lacs. By May, it had fallen further to ₹1.85 lacs - now below his purchase price. Panicking, Vikram sold all his shares, converting his paper loss into a real loss of ₹15,000.

Ironically, those shares would have been worth ₹2.7 lacs had he held onto them by August. Vikram locked in his losses by selling during a temporary dip and missed out on the recovery.

This difference in the stock price on a daily or monthly basis is usually known as volatility. Most individual investors are unable to handle this volatility and sometimes make irrational decisions.

If a share's price rises, they will continue to hold it, assuming it will increase further. However, once the price starts to fall, they sell to reduce their losses as they feel they will lose more money if the price drops further (below their purchase price).

Real estate is also a growth asset class and has yielded significant returns in selected pockets of the country. It's a myth that property prices only go up every year. They are also subject to price fluctuations and, more importantly, illiquidity.

To ensure that you don't lose money, it's recommended that you invest it in a mix of asset classes (also known as portfolio diversification) based on the duration you want to stay invested.