The risk of losing your money
You can also lose money if you invest your savings in an unplanned manner or without understanding the risks associated with investing in different kinds of products.
Let’s first look at the different areas (or asset classes) you can invest your money in.
There are 4 primary asset classes most individuals can invest their money in:
1.) Equity – This also refers to stocks, which are traded in the stock market.
2.) Debt – This refers to products like Fixed Deposits, Govt. bonds, Public Provident Fund (PPF), National Saving Certificates (NSC) etc.
3.) Real Estate – Residential and commercial property or land.
4.) Commodities – Stuff like Gold, Silver, etc.
In financial terms, the risk of an asset is defined as volatility in the price of that asset.
What this means is 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 too much (either up or down in the short term).
The risk is usually directly related to return – i.e. the higher the risk, higher the expected return. Let’s look at each of the asset classes.
This is a high risk / high growth asset class. Your money can grow significantly but it can also lose value significantly. These products have given average annual returns of around 12% to 15% per annum over the last 20 years.
These are low risk and low return products. Your FDs or PPF give you an annual return, which is pretty much assured. Over the last couple of years, they have given a return of 7 to 9% p.a.
These are again high-risk products, which give high returns over a long term. They are also very illiquid because it’s difficult to sell real estate quickly if you need money urgently.
Rise or fall in prices of gold is based on demand and supply in the international market and its prices can see volatility at times.
To understand the risk of losing money better, you need to understand the difference between a ‘paper loss’ v/s a ‘real loss’.
Let’s say you have Rs 1 lakh 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 Rs 100 and buy 1000 shares of the company for Rs 1 lakh.
In 2 months time, the price of the share goes up to Rs 120. You are very happy, as your investment has grown to Rs 1.2 lakhs.
You have made a profit of Rs 20,000 – However this profit is on paper only and until you sell your shares, you will not have a real profit.
Let’s say you decide to hold on to the shares assuming the price will go up more.
However, 1 month later the price of the share falls to Rs 110.
Your investment is now worth Rs 1.1 lakhs and compared to 1 month earlier, you now have a paper loss of Rs 10,000.
After another month, the stock price falls to Rs 90. Your new paper loss is Rs 20,000 compared to the previous month.
However, if you look at the total scenario, 4 months ago, you bought 1000 shares at Rs 1 lakh. They are now worth Rs 90,000 – So your net loss is only Rs 10,000.
However, this is still on paper as the no of shares you own is still 1000. Your loss will become real if you decide to sell those shares now at Rs 90.
If you continue to hold them for the longer term, the price might increase to Rs 150 or 200 and you will again make a profit.
This difference in the stock price on a daily or monthly basis is what is usually known as volatility. Most individual investors are unable to handle this volatility and sometimes end up making irrational decisions.
If a share’s price is rising, they will continue to hold it on the assumption that it will rise further. However, once the price starts to fall they sell to reduce their losses. If the price falls further (below their purchase price), they will lose more money.
Your money may go up and down in the short term, but over a long term, it’s most likely to go up.
Real Estate is also a growth asset class and has given great returns in selected pockets of the country. It’s a myth that property prices only go up and 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.
If you are 25 years old and earn Rs 50,000 and save Rs 20,000. Out of which you want to save Rs 10,000 per month towards retirement. Then almost 60 to 70% of Rs 10,000 should be in equity for the next 20 to 25 years so that your money grows fantastically (the risks are usually averaged because of the long-term duration of investment).
However, if you are 55 years old and nearing retirement, then your exposure to equity should be reduced and your portfolio should be heavier on the debt side as you will require stable income.