Every human being has fallen down several times before learning to walk. Every rose has a thorn and every medical practitioner has to see blood. All this is part of system, one cannot ignore them.

Similarly, inflation, taxes, government policies, geo-political situations and economic cycles affect all investments. These risks exist in system. There is no way one can prevent them. Inflation will reduce the real rate of return from all forms of investment, may it be debt or equity or property. Similarly, taxes eat into the final returns in the hand of investor. In a communist economy wealth, creation is difficult, irrespective of risk taking ability of an individual. Likewise, if local currency is revalued all forms of investments will get impacted. Risk that exists in system is called “SYSTEMATIC RISK.”

There is absolutely no way to a systematic risk. However, by adopting time averaging (popularly known as Rupee Cost Averaging or Systematic Investment Plan) one can reduce the impact of systematic risk. Impact of risk is averaged out by investing fixed amount at fixed interval. Since more investment units will be bought at lower cost and less investment units at higher cost, over a prolonged period, averaging will start working in investors favor. Please note investment could be in any class of asset. It could be in debt, equity, or property. Another strategy, which is superior to time averaging, is value averaging. However due to it’s complexity it is usually not only recommended.

Another category of risk is “Unsystematic Risk.” Risk which does not exist in system as a whole but which is specific to a particular asset class or particular investment product is called unsystematic risk. Other name for unsystematic risk is specific risk.

Crashing of property prices in mill area of Mumbai due to unfavorable court judgment is called unsystematic risk. Similarly, if CEO of Wipro Ltd resigns causing stock a price to tumble than it is called unsystematic risk. Another example could be of crashing of gold prices due to government control.

Find out your risk appetite!

Diversification is best solution for controlling unsystematic risk. Diversification has different meaning to different investors. There are some who invest in six different floating rate schemes of mutual funds and feel they have diversified. Others feel that by investing in different stocks they have diversified e.g. their portfolio will consists of HLL Ltd., Marico Industries Ltd., Gillette India Ltd and P&G Ltd. A closer look will tell you that all are FMCG stocks. Yet, there are few who diversify through different investment vehicles e.g. They would have mutual fund schemes which invest in equity, ULIP which invest in equity and would also have rendered services of portfolio manager for their equities.

Diversification means investing in asset classes which has negative correlation. In nonprofessional’s language, it means that when performance of one asset class goes up, other asset class falls down. This will ensure that overall portfolio returns remain stable. If the explanation has to be further diluted, it would state that do not place all your eggs in one basket. By diversifying the portfolio, unsystematic risk is significantly reduced.

There can never ever be risk free return. Risk free return does not exist. In fact, return is solely a factor of risk. However, proper understanding of risk will assist in generating higher returns with same amount of risk.

The author is a Certified Financial Planner. He may be reached at gmashruwala@gmail.com

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