7 Techniques To Balance Investment Risk-Reward For Your Portfolio!

Making the right investment decisions is a skill as these decisions are affected by various factors. Assessing the investment opportunities in detail is crucial for investors. The core purpose of investment is to retain and grow the value of money over time. Investing in different instruments helps investors attain their financial goals against the growing effect of inflation.

However, expecting rewards from investments is accompanied by various risks. Determining the risk factor is a crucial part of every investment. Striking a balance between risk and reward can help investors in overall and efficient financial management.

Importance Of Balancing Risk And Reward In Investing

An investor cannot expect to earn high rewards without having exposure to risks. Risk refers to the uncertainty over the returns of an investment. The reward is the return earned from the source of investments. Adjusting risk and returns helps investors navigate efficiently throughout the investment journey.

Moreover, balancing the risk and reward helps investors in:

• Making an informed investment decision in crucial times 
• Managing risks efficiently 
• Allocating and balancing a portfolio 
• Gradually expanding the investment horizons 

Types And Sources Of Investment Risks

Assessing the types of investment risks in financial management helps manage them with care. Moreover, different types and sources of investment risks have different properties. Therefore, its management should be planned according to these properties.

Some of the common types of investment risks are as follows:

• Market Risk

Market concepts like demand, supply, prices, volume, etc., have a significant impact on any investment that is traded in the market or has exposure to the market. Price volatility is the most crucial factor of this, and it has a significant impact on the source of investments.

For example, if a promoter of a company reduces its stake, the volume of shares in the market increases. Moreover, sentiments among public investors are driven due to such actions. In such a scenario, there is a chance of price fluctuation in that company’s stocks. Not only company-specific events but political events also affect the price of shares and hence can affect the value of your portfolio. Check out the graph below to explore how BSE Sensex dropped on 4th June after the election results.

• Credit Risk

When a borrower defaults while making a repayment, it can affect the overall flow of funds for the instrument. The risk of such default is known as credit risk. 

For example, if you are an investor in a peer-to-peer (P2P) lending space and the borrower defaults on your investments, then it will be considered a credit risk. Such credit risk leads to financial loss for the lender. 

• Inflation Risk

Inflation is generally regarded as a price rise. The price rise reduces the purchasing power of an individual. It creates an inflation risk.

For example, if the inflation rate is higher than the potential returns from the investments, the investment fund can be eaten up by inflation.

• Liquidity Risk

Investment marketability is a crucial feature. If an investment is facing difficulty finding buyers at a suitable price, the risk of liquidity lurks over it.

For example, a stock becomes illiquid when there are no buyers for it in the market.

Balancing Your Risk and Reward

Now that you have understood the different risks involved in the investments, the next step is to understand how to balance this risk with appropriate rewards. Some techniques are usually used by investors that can help strike a balance between risk and reward, such as: 

1. Finding Your Comfort Zone

Every investor is different in terms of his/her financial objectives, corpus requirements, holding tenure, experience, and personal attributes like age, capacity, social setting, etc. Therefore, one strategy or size may not suit all. Assessing the appropriate and suitable investment is accompanied by determining the comfort zone and emotionally resilient risk level in terms of these factors. 

Investors are classified based on their risk-taking abilities:

• Risk-seeking or aggressive investors
• Risk-neutral or moderate investors
• Risk-averse or conservative investors

2. Weighing Risk And Reward

Investment risk can be of different types. An investment opportunity may be affected by various risks. Assessing it will help investors decide the nature of the security and its weightage in the overall portfolio. It can be done in comparison with the return from that investment. 

Some tests like cost-benefit analysis and break-even point may help investors check the risk and reward associated with an investment.

3. Spreading Your Risk To Maximise Rewards

Modern Portfolio Theory (MPT), coined by Harry Markowitz, focuses on diversification and portfolio selection. The concept of diversification is closely intertwined with risk and reward. When funds are diversified into different instruments based on sectors, market exposures, size, etc., the risk is also spread across these instruments. A perfectly diversified portfolio will include different types of instruments such as stocks, mutual funds, corporate bonds, securitised debt instruments (SDIs), government securities, gold and other fixed-income instruments.

For example, when a high-paying investment is stuck in the short market volatility, the long-term instruments are one of the best low-risk investments and satiate that period with moderate returns. Thus, diversification is a crucial key to a successful portfolio.

4. Hedging And Insurance Strategies

People make investments with great enthusiasm but forget to safeguard them. It may result in potential losses for their investment. Hedging is a niche trading term and a technique used in risky instruments when an investor takes another position (opposite) in the market, along with a regular position, to protect from risky investment. The derivatives segment of equity markets is a classic example of it.

Some investment-linked insurance helps fight the specific risks of that investment. For example, mortgage insurance for mortgaged houses. 

5. Role Of Time Horizon In Risk-Return Trade-Offs

Investment tenure is a crucial factor for balancing risk-return. It can be long-term or short-term. Short-term investments may provide lucrative and quick returns but would have high risk. Similarly, long-term investments may provide a slow return but would be a low-risk investment. Balancing the right mix of short-term and long-term investment can help investors satiate their varied financial goals.

For example, a large-cap mutual fund can provide a substantial return in the long term, and early redemption can cost some returns. However, if the investor also has money market mutual funds, then in the short-term it can satiate the near-term goals.

6. Checking Return On Investment (ROI) And Market Analysis

Before making any investment, potential returns calculation can help investors plan their portfolio. While selecting an investment, different factors need to be considered. If the potential returns match the financial goals and risk is in the comfortable zone, the investment can be beneficial for an investor.

One of the instruments to assess the returns is the return on investment (ROI). It is the final amount of investment (while selling or while assessing) and the cost paid for that investment. Usually, it is expressed in percentage (%) form. For example, if an investment is purchased for INR 80 and sold for INR 120, the ROI is 50% [(120-80)/80=0.5*100].

Similarly, market analysis helps investors understand the investment thoroughly. Fundamental and technical analysis, paired with market information, can help investors amp up their investment game. Market analysis includes checking the company's functions, financials, industry and related market news.

7. Staying On The Top Of Changing Market Conditions

Investment is more of a journey than a simple destination. The market is an ever-evolving space. The aspirations of buyers and sellers clash to navigate prices in the market and affect the growing investments. Moreover, other factors help investors manage their financial goals and risk tolerance. Regular portfolio review helps investors rebalance portfolios. Investors can stay informed of market happenings and seek professional advice from their financial advisors.

Conclusion

It is observed that when there are high returns, there is a high risk associated with the portfolio. One can balance investment with several techniques. Balancing the risk and reward for investors can help investors stay longer in the market and earn better returns. One proven technique to balance your portfolio returns is to diversify it with different types of assets including stocks, mutual funds, gold, government securities, fixed-income opportunities and others. Fixed income instruments investments have become easy! Sign up to Grip Invest today and amp up your investment game!

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