Smart investing: minimizing the risks of market-linked investments
Market-linked investment instruments play a crucial role in achieving investors’ financial goals, maximizing their wealth creation and beating inflation over the long term. Depending on age, risk tolerance, return expectations and target requirements, an adequate portion of the portfolio should be allocated judiciously to market-linked instruments. For example, if you are a young investor with a high risk appetite, limited commitments, and an ambition to build a huge corpus for your future, you cannot ignore market-related investments.
Now, depending on the underlying asset class, a market linked investment can be a debt, equity or hybrid product (i.e. a combination of debt and equity). However, in order to obtain better returns through market linked investments, it cannot be ignored that they also carry a higher risk compared to unrelated instruments like fixed income instruments. You should therefore be aware of these crucial elements before investing in a market-linked instrument.
Types of market-related instruments
Some of the popular market-related instruments available in the market include mutual funds, unit-linked plans (ULIP), direct stocks, and the National Pension Scheme (NPS). These market-linked instruments could offer a high return, but they also carry a higher risk compared to a fixed income product. If you are a risk averse investor, you should avoid investing only in market-linked instruments.
Who should invest
If you are young, have limited commitments, and are willing to take a higher risk to generate better returns, a market-linked instrument can be an attractive investment option. Even older investors with limited liabilities and healthy finances protected, for example, by adequate insurance protection, might also consider smartly investing a small portion of their funds in market-related products. Market-linked instruments can beat inflation and generate a high real rate of return (i.e. nominal returns less applicable taxes, investment costs, etc.).
However, if you are looking to pursue a crucial short-term goal, you may want to avoid investing in a market-linked instrument. It is generally safer to invest in a market-linked instrument to achieve long-term goals. Additionally, some of the debt-focused market-linked investments are comparatively less risky than the equity-focused market-linked investments.
How to reduce the risk?
You can reduce the risk by investing in products linked to the market through optimal diversification and by investing according to the systematic investment plan (SIP) method. Instead of investing the entire corpus in a single market-linked instrument, you need to diversify it into different types of instruments involving different asset classes. For example, you can invest money in stock mutual funds, debt funds, etc. You can further diversify into different types of plans offered by different companies in the equity and debt fund categories.
Diversification helps reduce market risk and minimize the impact of volatility on the portfolio. Investing in market-linked instruments through SIP can reduce the risk of volatility and benefit from an average rupee cost in the long run. Choosing the right mix of instruments based on your financial goal and risk appetite can further reduce the level of risk.
Invest for the short or long term
Since market-linked instruments are more exposed to market risks, investing for the long term can also reduce risk to a large extent. However, a product like a liquid fund carries comparatively lower risk than most other market-linked instruments. It can offer you great flexibility and moderate to good returns as a short term investment vehicle. If you are looking for a higher return and don’t have liquidity constraints, go for a long time horizon when investing in a market-linked instrument.
How much should you invest?
The allocation of investments should always be in line with your financial goals and cash flow needs. Market-linked investments have better potential to provide a promising long-term return compared to short-term investments. People who invest all of their money in a market-linked instrument may suffer losses if they have to exit short-term investment due to tight liquidity.
It would therefore be prudent to argue that it is better to invest this part of your savings in a market linked instrument that you will not need in the short term. That said, the allocation to market-linked instruments should be higher when you are young, and it should gradually decrease as you get older.
The writer is CEO of BankBazaar.com