All last week we’ve been talking about how it’s time parents encourage their teenagers to understand how to save and invest. We also looked at the kind of investments your teens can start with and the benefits of starting early.
However, there is more to investing than just starting early, diversifying, and investing goals. We mean financial risks. These risks will play a role in the decisions your teens take about money. Knowing the impact these risks have and ways to overcome them will help your children become better investors of tomorrow.
Before we look at the kind of risks associated with investing let us know more about financial risks.
Know Financial Risk
Nothing is certain or guaranteed when it is money. This uncertainty or possibility of a loss is what financial risk is about. Such risks are not just factors while investing, but they are present in other areas like borrowing too.
The most common risks associated with investing are risks due to business, volatility, inflation, liquidity, interest rates, and credit risks.
Can investors overcome these financial risks? Yes, they can if they diversify their portfolios, minimize volatility, and avoid making emotional decisions.
Financial Risks and Investing
Financial risk is a term investor uses while investing. That’s because you (the investor) put in money to buy assets that could grow in value over the years. Every time you invest, you accept the risk of losing the money you’ve put in.
Understanding that the risks don’t stop after your asset has grown in value is important. Risks will always be a part of any investing journey. That is what your teens must understand before they start investing.
Types of Risks in Investing
Volatility is the frequency of price changes in a particular stock price. For instance, a company’s stock could move up or down for plenty of reasons. Volatility is unpredictable and can happen at any time for varied reasons. One of the reasons could be the company news or quarterly results. The economic environment in the country and world can also make the markets volatile.
Business risk means the risk of investing in a specific company. You may have thoroughly researched before investing, however, things in the business can change over the years. The price of your stock depends on how the company performs during the year.
If the company underachieves or goes shuts down, then you (the investor) may suffer financial losses. But, if the company does well then you will see the stock prices rise.
Inflation is always a factor as the prices of goods and services can rise due to increases in demand, hikes in input costs, supply issues, and more. High inflation tends to decrease the purchasing power of your money. For instance, if you have Rs. 100 and the inflation rate is 7%. Your one hundred would be worth only ninety-three the next year. (100-7 =93)
Inflation comes into play when the returns on your investments aren’t high enough to beat the inflation rate. You lose money when the rate of return on your investments is lower than the inflation rate. It is true when you invest in low-risk assets like fixed deposits (FDs).
Liquidity is how easy or difficult it would be for you to buy or sell your asset. Often liquidity is an issue when it means selling a house, land, or any other immovable asset. The more liquid your assets are, the easier they are to sell and buy. This rule holds when it is equity shares.
It is the lender who always faces the credit risk, i.e., the risk that the borrower may not be able to repay the borrowed sum. However, if you invest in bonds then credit risk comes into play. It is when the bond issuer(borrower) won’t pay back the bond once it matures.
For instance, the credit card lender takes on the credit risk when someone spends money using a credit card but may not be able to repay it.
Interest Rate Risk:
You (as an investor) always face the risk of interest rates going up. It is true when you invest in bonds or FDs. For instance, if the interest rates go up but you have invested in a bond already. You will lose out on the increase as you took a bond before the rise. Similarly, selling a bond in the secondary market becomes difficult when the interest rates go up as other investors can invest in bonds with higher rates of interest.
Financial Risks and Borrowing
We are sure you have taken a loan, whether it is for a home, finer things, or pursuing higher education. Do you remember the lender, i.e., the bank always considers their risk before lending money?
The risks come into play when you cannot pay back the loan taken. The next step would be incurring interest, penalties, and added fees if you default on EMI payments. For instance, if you took a loan with your home as collateral, you risk losing the home when you can’t pay the loan. Help your teens understand that the consequence of non-payment are the risks when they borrow money for any purpose.
How can your teens minimize financial risk?
As you teach your teenagers about financial risks, it is vital they also know how to reduce their risks. Here are ways to do it.
Build A Robust Financial Foundation
Experts recommend putting down the basics of a good financial foundation. The basics must include budgeting, saving, and understanding goals before investing. Having a robust financial foundation will help you build a fortune and not take an unnecessary loan to invest. Not having a fallback strategy can mean the difference between suffering losses and creating wealth.
Diversify Your Portfolio
Diversification should be a key mantra your teens follow. It is one of the best things you can recommend, reducing investment risks. Your asset allocation is how you spread your investments in different assets. The more varied your asset allocation the lower your risk. It is because if one investment falls, the rise or stability in the value of other assets can compensate for the losses.
Don’t Try to Beat the Stock Market
Investing to create wealth is not about beating the market. With so much information available young investors learn about advanced investing strategies that could be too risky. Young investors may choose to beat the market, which can backfire. Your teens can still play with their portfolios and try innovative investing strategies, but they must be ready to face their potential losses.
Don’t take Decisions based on Emotions
Have you heard people say emotional decisions are most often wrong? Well, not talking about emotions when discussing financial risks is a mistake. What happens when something goes wrong with your child’s investments? They may have an emotional reaction to it. Discussing how emotions play a role in investing may help them avoid expensive mistakes.
We are sure you’ve seen new investors react when the market falls. They tend to panic-sell fearing losses or start buying when the market is high as they fear missing higher returns.
Teach your teens how to find a balance between avoiding excessive risk while taking enough risk to achieve their target returns. Don’t forget to explain that risk tolerance changes with age.
Financial risk is unavoidable. While talking about money, remember to talk of financial risks, the role it plays in their finances, and how your teens can minimize them.