Not taking enough risk increases risk

Not taking enough risk increases risk. It initially sounds absurd but after careful consideration, it made sense in relevance to the field of finance.

An astonishing number of people want to keep their money safe and still get good returns. Now, it’s obvious to anyone with honesty and basic common sense that this is very unlikely to happen. You can keep your money secure and get single digit returns, or be willing to take some risk and aim for much better returns. Keeping one’s money safe and getting high returns is something only the previous generation has enjoyed. In their earning days, returns were as high 16% to 18% in relatively safe avenues like fixed deposits. Even bonds yielded over 14%. When one can get such high returns without risks one tends to become risk averse. But in today’s world, following the advice of keeping all your money safe could have a harmful effect on future financial security.

Consider the case of an average middle class household which spends about Rs 15,000 a month on routine expenses including electricity, telephone, gas and so on. Suppose the income earner in the household say of 33 years age believes he should save up to 30% of his income, including his Provident Fund contribution. Why 30%? He has heard the rule off thumb which says that if one saves at least 30% of his income, it is generally enough to take care of future needs. So he contributes Rs 1,200 to the PF. His take home pay is Rs. 21,000 and he manages to save about Rs 5,600 month, which is less than 30%. His gratuity has not been factored into these calculations, but it is also part of his savings. He has a term plan for Rs 15 lakh for which he pays Rs 4,500 month. For now things look good.

Let’s take a look at the future. The house hold earner’s two year old son B will start preschool (Rs 800 a month) and go on to school (Rs 1,500 a month). B will also incur tuition expenses from classes nine through 12 and his graduation (Rs 9 lakh), and wedding expenses (Rs 7 lakh, 25 years from now). Three years from now, the head of family (earner) will buy own home costing Rs 28 lakh. He estimates that he will have to liquidate all his savings which would amount to Rs 15 lakhs, three years from now. From that point on he will be paying out monthly installment of Rs 1.72 lakh a year for 20 years. As you can imagine, the 30% savings rule has gone off a toss by this point. When the house hold earner retires at the age of 58, after 25 years of service he will have a corpus of Rs 72.7 lakh (assuming that savings yield a compounded return of 8% a year).

Twenty years from today, after B graduates we assume he will get a job and will no longer depend on his parents. So, we can expect their expenses to drop by 20%. Also, after retirement, the expenses are expected to drop another 20%. After retirement, expenses are assumed to grow by just 3% year on year. Gong by these projections, if the corpus grew by 8% during earning years and continues to earn 8% after retirement too. It will last until his 74th year. However, if he had invested in other growth options like stocks and mutual funds which yield an average return of 12% in the first 25 years overall, and 9% after retirement he will be comfortable beyond his 80th year.

The point here is that if you rely on only risk free investments even if you have good savings, deficits will show up later because your money will not grow fast enough. When growth investments are included, the same level of savings will support your family for a longer period.

Now many will raise the doubt that, by taking risk, they stand the chance of losing their savings. True, your savings may well be exposed to unnecessary risk if your approach is speculative, and if you don’t give your investments enough time to do their job. Time can reduce the risk because it’s over time that stocks and mutual funds can yield good returns in spite of the fluctuations in between.

If you are a very conservative investor, there is the risk of providing inadequately for your future as is always relative. Prudent investment and time can substantially reduce risk. And odd as it sounds, not taking enough risk does increase your risk, in the end.