Understanding the Two Key Risks in Investment: Inflation and Volatility


There are many different types of risk involved in investment but primarily there are two important risk which an investor should keep in mind.

1. Inflation: Inflation is a major risk in our long-term goals. Let us see with an example below. Suppose, if there is a goal of higher education of kid and it is falling 10 years from now then in that case the value of goal at 7% will multiply as under.

As shown in above table, goal value will almost double in 10-year period so if your goals are far away inflation will make them much bigger and you will have to invest more money to meet such goals. Now to meet this risk, which is created by inflation investors will have to invest more in the asset class which can beat inflation. The primary asset class that can beat inflation is equity. So, for goals which are long term major risk is inflation and money invested for long term goals should be more equity oriented.

2. Volatility: Volatility means fluctuation in asset prices and not the permanent loss. When we ask about risk most of the investor believes that risk is permanent loss in value of investment but actual risk is not permanent loss but it is fluctuation in the prices of securities. If you are investing in equity, then there can be a loss in individual company but not in portfolio over a long run. 

Volatility is a major risk to short term goals and not long-term goals.  If we have a goal coming after one year, then inflation is not major risk but volatility is a major risk. Let us see calculation of a goal coming after one year.

As shown in the above table if the same goal is coming after one year, then the goal value is not increasing much and it can be met with slightly higher amounts. So, inflation is not a major risk for this goal. Now it is important to understand that if investment for this goal is made in equity instruments and if markets fell at the time when funds required for the goal then we will have to withdraw funds at a reduced value and this will result in losses. So loss occurs when we withdraw money at the time of market fall. From this discussion, it is clear that investment for this goal which is short term cannot be made in equity-oriented instruments or any other instruments which are volatile. For this goal, investment has to be made in any short-term bond fund or Fixed deposit where there is absolutely no volatility.

From the above discussion it is easy to understand that “Inflation & Volatility” are two major risks that investors face in their investment and based on their investment horizon they have to construct the portfolio in such a way that for long term goals they are investing more funds in equity-oriented instruments so that they can beat the inflation as volatility over a longer period is expected to average out and markets will go up over the long term. For short term goals, investments should be made in fixed income securities where there is no price fluctuation.

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