What is the Difference Between High Risk and Low Risk Investment?

Introduction

Risk can be defined as the exposure of an investment vehicle to loss. You can simply understand it as the potential of losses to occur over time due to external factors and forces beyond your control. It depends on the probability of any negative event occurring and its impact on your investments. Comparing low-risk vs. high-risk investments is not possible without considering the investor’s financial goals and expectations. An analysis of your complete financial portfolio defines your risk-taking capability and how an investment instrument can increase or decrease your risk exposure. In this article, let us understand the differences between low-risk and high-risk investments along with their impact on your investment.

What are Low-Risk Investments?

Most people choose to invest in low-risk investments because these put little at stake, and therefore the investment loss is not as significant for the investors financially. Low-risk investments also have lower return potential than other types of securities, like stocks or bonds.

However, low-risk investing does not guarantee that no losses will occur. It rather means minimising potential risks. There are many low-risk investment options available. These all provide a natural balance between risk and returns while boasting of security against a devastating loss. If you are a risk-averse investor, you can pick from the following low-risk investments.

Fixed Deposit

Fixed Deposits (FDs) are an attractive investment for those who want the security of their capital. They offer a promise of assured returns plus the opportunity to earn interest on your money, which you can withdraw at any time with zero or nominal penalties or withdrawal fees.

PPF

Public Provident Fund (PPF) is a government-backed retirement plan that serves as an easily accessible and tax-efficient alternative to other savings plans, such as the Employee Provident Fund (EPF). It is particularly beneficial for individuals who do not have direct access to pension plans.

Life Insurance

Securing the future of your loved ones is a key responsibility that comes with being the breadwinner for your family. The best way to manage their finances in your absence is by taking an endowment (protection) plan or a life insurance policy. 

An endowment plan is a 'with profits' life insurance policy that offers savings combined with coverage. There is a payout regardless of whether the policyholder survives the term or not.

If you are an investor with low risk tolerance, the traditional endowment plans are suitable for you. They generate guaranteed returns for you by investing primarily in fixed-income securities like government bonds and corporate paper.

What are High-Risk Investments?

An investment is considered high risk if the chances of losing a large percentage of your capital are high or it is projected to underperform. For example, if an investor’s chances of losing money on their investments are 50%. It might seem risky for them whereas, on the other hand, another investor may not consider it high risk. The other investor may consider an investment very risky only if there is a 95% probability of not earning the expected return.

Direct equities

Equities are the best way for risk-takers to achieve their financial goals. Over time these assets have consistently outperformed other forms of investment. The fact that they generate the highest returns among other instruments, cannot be ignored. However, investing directly in the stock market requires time and skills to study companies, sectors, and economic factors. Direct investment in equities is not suitable for all. Therefore other investors can get exposure to its benefits through a mutual fund. 

Equity funds

Investors who lack the time or expertise to invest in equities can invest in equity funds. The money pooled in these funds is managed by experienced fund managers. They have the expertise and skills to generate higher returns from your investment. They minimize risk to some extent by picking profitable companies for you.

ULIPs

Unit-linked insurance plans (ULIPs) are a variant of the endowment plan, with investments in the portfolio being linked to stock markets. Investors with a decent risk-taking capacity can consider investing in ULIPs as they offer considerably high returns. However, the inherent volatility compared to mutual funds or stocks is much lower, making your investment safer. 

Parameters for Risk Assessment

The risk of an asset is subjective to an individual’s capacity to take the risk. It can be assessed based on certain parameters, such as- 

• Diversification is important to minimise the risk of an investment portfolio. High dividend-paying stocks of Fortune 100 companies are generally considered very safe and you can even expect medium to high returns from them over years. But even they are subject to market volatility, which means that their prices may suddenly drop or increase and you may suffer a loss instead. However, you can save your money by investing it across different instruments.For instance, if you are an investor who holds all of their money in one stock with the potential for high returns, you are taking a huge risk. However, if you have invested in 10 stocks across different sectors/industries, there is a greater chance that at least some stocks will perform well. 
• Time Horizon is another parameter to consider, as most investments may mitigate risks over their tenure. However, an investment may not generate desirable returns if you withdraw your funds before the maturity period.For instance, you hold a portfolio of low-risk Treasury bonds, which may seem like a very low-risk investment, but it is still risky. If one bond crashes, it would be devastating for your portfolio. In contrast, holding investments with different types of risks for their entire tenure enables you to minimise exposure in case of unexpected incidents.
• Expectations from your investment must also be rational. If you are expecting high returns from an investment, it is important that you also understand your risk tolerance and the probability of the instrument underperforming. A good understanding of market volatility and its impact on your investment will help you avoid grand assumptions. Keeping your expectations in check ensures you achieve reasonable returns based on your financial goals. 

Takeaway

Investments cannot be classified as purely low-risk or high-risk. Each investment instrument includes a bit of both types of risk. It is not the only parameter of comparing instruments. The intensity of risk associated with an investment majorly depends on the investor’s appetite for taking risks. Ideally, you should create a portfolio that is invested in various types of low-risk and high-risk investments to get balanced returns. This strategy works best for most investors but may vary based on an individual’s goals and their level of risk tolerance.

Summary

Every investment you make is associated with a certain degree of risk.

Yes, you heard it right - every investment from fixed deposits to equity funds involves some risk element.

Based on the degree of the risk in the instrument, we can classify them into Low-risk investments and High-risk investments.

Low-risk investments are typically considered to be instruments that have low volatility and do not fluctuate much in price. Some of them are fixed deposits, PPF, life insurance, etc. Low-risk investments offer reasonable returns while boasting of security against a devastating loss.

High-risk investments are usually stocks with high volatility and their prices can change dramatically over time. Some examples are direct equities, equity funds, ULIPs, etc.

These investments are considered high risk as the chance of losing a large percentage of the invested capital is high. However, the higher rate of return generated by these investments also must not be ignored.

While planning your finances, you must assess the risk of an instrument and also evaluate your risk-taking capacity. The estimation of risk is subjective, as it depends on your current financial needs and future goals. Some parameters for risk assessment are diversification, time horizon, and expectations.

To get balanced returns from your investments, you must create a portfolio of diversified investment instruments. A healthy mix of low-risk and high-risk investments is necessary to get balanced returns.

Key Takeaways

• Low-risk investments offer stability and peace of mind.
• High-risk investments can lead to major financial rewards.
• Low-risk investments are great for long-term planning.
• High-risk investments should only be made if you are comfortable with the risk associated with them.