Friday, September 12, 2014

Wealth Management : Managing Risk

What is Risk? We often hear that Risk has to be managed. Risk is the uncertain outcome that we have not predicted or even if we have predicted we feel that, it is too uncertain for that to happen. We all know that we are going to die one day, but we do live our life with the notion that we are going to live eternally. (On a philosophical note, if we start living with the awareness that we are going to die one day, we all will just stop living. It's also interesting to note that we do not only live our life but we try to manage the life of our grand children. A common statement in India is to earn enough so that the next 7 generation can live on what I earn. Though the fact is that there are rare seven generation who have lived comfortably, not even Mugals. The point to note here is to be realistic with what we want to achieve with our life.)
We deal with risk everyday. When we put our money while travelling at different locations, we are mitigating the risk of money getting stolen from one location. There is an old joke where a guy
having a travelling pass and still buying three set of tickets in case he loose them one after another. I am sure, he would still not be comfortable and would still be worried with the fact that everything still can be stolen. There are two important things to note here. One is that each one of us have a different reaction towards risk. Some of us are comfortable with higher risk and some are completely risk averse. Why this tendency is important? For one simple reason that the wealth portfolio has to be build keeping in mind the risk tendency of an individual. A person with high risk aversion, investment in equities is not a good idea. What's the purpose of a portfolio where one cannot even sleep properly in the night. Even if someone is still keen, they need to go through a behavioural exercise of remaining calm in turmoil. The second aspect of the discussion is the cost of risk. We want to manage risk but at what cost? We at times take too much insurance because the easiest thing to sell in the world is death. It's the notion, whose outcome is for certain.
Now let's look into the risk itself. The risk are basically categorised into two types. One is systematic and another one is unsystematic.
  • Systematic risk: Systematic risk is one which affects everyone in the universe. A war is a kind of systematic risk. One can do little to mitigate that kind of risk.
  • Unsystematic risk: Unsystematic risk is one which affects locally. A scam in a company or sudden loss of job is a kind of unsystematic risk. This is the risk which should be diversified to manage it. Investing all the money in a single share or all in gold can lead to unsystematic risk.
What we can do to handle risk. The golden rule of mitigating risk is to not to put all the eggs in a single nest. Keep diversifying as it reduces the risk. A word of caution is however that too much diversification is also not suggested, as it can lead to high cost of maintenance and can make the returns suboptimal. Remember finally it's the growth which should be the core of portfolio with the notion of risk in a managed state. Do not put risk in the core and growth as an outcome of that.

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