In the article on Importance of asset allocation, we saw that determining your risk profile is the key to making successful asset allocation. We saw that proper asset allocation will protect you from losing your money and will help you become rich. Here we try to see how taking risk will help you achieve high rewards.

We all know that stocks are the riskiest investment option. This is because they have a risk of capital loss. If the company sinks or is mismanaged as in the case of Satyam, you can end up losing all your money. However if you have managed to select a company like Infosys, you will end up making money many times over.

But this is just one type of risk. The other type of risk is interest rate risk. This is common in debt investments like income funds and gilt funds. As the interest rates go up, the yields from these funds go down, thus making investors lose money. The vice versa is also true.

Then there is an inflation risk, where the inflation (the phenomenon of rising prices) erodes the value of your investment. This is also associated with debt investments, having fixed interest rate. So if you have an FD of Rs 10,000 offering 7% interest for 2 years, the value of your principal is less than what it was when you opened the FD account.

To become a successful investor, you need to be aware of the different types of risks involved. This will help you make uniformed decision. The key to achieving perfect allocation is to distribute your portfolio between equities and debt. While equities make ideal investment from long term perspective, debt should be used as a short term investment.