Investment strategies for small investors

RELATED NEWS Why are markets taking a nasty ‘U’ turn? How to pick the right mutual fund? How to play your cards right in the stock market Concentration v/s Diversification – What to choose? Things you should not expect from MFs

A lot is being written about what a small retail investor should do especially in the face of uncertainties revolving around the stock markets. Most of the writings stress on the fact that the small retail investor's money is his / her hard-earned money. That he / she has no access to information and is vulnerable to all the fraudsters and conmen.

Reflecting on the above, I strongly agree to the points above, viz., hard-earned money, poor access to information, vulnerability to be duped, etc. However, does this reality warrant a change in the financial plan of the small retail investor?

Many securities market crashes have happened across the world and some investors have lost everything in such crashes. However, there is no correlation between who survives market crashes and whether the investor was a wealthy investor or a retail investor prior to the crash. Whether an investor has small sum available to invest or huge money has no relation to the magnitude of the loss. Most often how one invests determines whether the investment would be successful in meeting the investors' future goals or not.

The first thing to keep in mind is to decide how much money to be invested where. Most often, one has found that an average investor has her money invested in various financial instruments, e.g. stocks, bonds, fixed deposits, savings account, small savings, mutual funds (either debt or equity or both), real estate, etc. The process of dividing one's money across various options is known as "Asset Allocation" in financial parlance. Investors at large, talk about how much amount is invested in various options, whereas financial advisors talk about percentage of the total investment. Thus, the reference to asset allocation is not very different between a retail investor and a financial advisor. However, the big difference comes in the approach to asset allocation or how the break-up between the various options is determined. Whereas many retail investors approach the asset allocation question in a more haphazard manner, a financial advisor weighs the options considering the risk appetite and return requirement of the investors against the nature of the investment option and tries to strike a balance. Thus an optimum asset allocation is decided in a scientific manner.

For every investor the combination of return requirement and risk appetite would be different. If that is the case, the solution also has to be different. Hence, what works for one may not work for someone else. We can explain this by looking at a very familiar situation. If two persons with high fever go to the same doctor, the medicine prescribed in both cases could be very different if the illnesses are different. The doctor, instead of giving a standard medicine, looks at the cause of fever and diagnoses the problem before considering an option to offer as solution.

A scientific approach to asset allocation is likely to help one achieve the financial goals in spite of the price movements in the market. The things normally considered to determine the risk appetite of an investor are:

• Time horizon, i.e. how much money would be required after how much time. Equity markets are known for their potential to deliver higher returns. However, the stock prices remain very volatile over shorter time periods. Incidentally, over longer time periods, the predictability of stock returns is much higher than shorter time periods.
• Whether one has taken care of the uncertainties in life through insurance and some liquid cash.
• The number of dependent family members one has
• Whether the professional income is high or low; whether it is stable or volatile; whether it is sufficient to meet the regular household expenses; whether the profession itself is stable or there is an uncertainty surrounding the same
• Age of the investor
• The level of debt one owes
• How would one react to an adverse event after investing in stock markets

The list above is not exhaustive and some investment advisors may add more points to have a better judgment of the investor's situation.

This, however, is only one part of the protection that the investor needs. The above approach may not protect an investor from conmen or fraudsters. Conmen generally appeal to the greed of individuals. When one gets into the web of the glib of these conmen, one puts in the money only to forget about the same. I strongly believe that the investor's most powerful weapon against this is to ask questions and understand how the promise will be delivered. If someone offers an investment avenue that promises very high future returns, it is a good idea to understand the underlying logic and economics.

The words "caveat emptor" are equally applicable in the world of investments as well. If something seems too good to be true, it might be. Remember the NBFCs / co-operative banks that offered very high interest on deposits or the plantation companies that promised the moon. Even today, certain stocks or equity mutual fund schemes are looking attractive going by their past performance. However, sustaining such returns in the future is a different matter altogether. Whether such returns are possible in future depends largely on how the future unfolds for the particular stock, or company, or the economy in general or a particular mutual fund scheme. Just because someone knows more than you and claims that the investment may fetch very high returns in future does not mean that the expert would be correct. It is observed, especially in subjects like stock markets, that an expert may at most know more questions than a layman, but may not know answers to all the questions.

The other day, an investor was met by an insurance agent, who recommended that the investor should buy a particular insurance policy that could give very high life cover and also offer high investment returns. The investor was more curious than an average investor and wanted to know more about the scheme. The agent told that the scheme does not take any investment risks (and hence does not invest in stocks) and invests only in government securities. When probed further, the investor found that the indicative returns were around 2% higher than the highest that can be given by any government security at that point in time. Obviously, the investor did not buy the policy and saved himself from a shortfall at a later stage - only by asking a few relevant questions.

Capital markets teach us a lovely lesson. It offers us many things that we may want, but only after we are ready to pay the price for that. Often the price is in the form of disappointment at a later stage - often when one cannot afford the disappointment, as it could be too late to repair the damage.

How much price one is ready to pay and in what form can however, be determined by doing little bit of homework and using the most powerful weapon - questions. When one is putting one's hard-earned money at work, being skeptical helps.

- Amit Trivedi

The author works with a leading mutual fund company. The views expressed are his personal views.

For more Views by Experts click here