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What is risk?
Risk is the possibility of losing money invested. A certain amount of risk is an inherent part of the investment process. Very rarely is money made at zero risk. Therefore, the key to successful investing is to identify your risk taking capacity and return objectives. Risk and return are inextricably linked. High risk investments such as equities promise higher returns, while low risk investments such as bonds and fixed deposits offer low returns. Your portfolio must, hence, be built keeping in mind investor risk and investment risk. Investor risk may be further classified into risk-taking capacity and risk tolerance.
Risk taking capacity
Risk taking capacity depends upon several factors such as investment objectives, personality, investment time frame, age, income, number of dependents, how much wealth you have accumulated, and so on. Let’s look at how each of these determines your risk taking capacity.
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Personality: Do you love taking risks in life or do you tend to play it safe? Most people carry their personality into their investments. So, someone who plays it safe in most aspects of life, may prefer low-risk investments, and vice versa.
Investment objectives: Defining your primary objective behind investing is critical. It could be creating wealth to meet financial goals or protecting savings from eroding due to inflation. Objectives determine expectations. Expectations are determined mainly by age.
For instance, older people most often invest with the objective of protecting their life savings from eroding due to inflation. Given this limited expectation, they have a low risk taking capacity.
Age: Creating wealth requires both, time and money. The longer you stay invested, the higher are the chances of earning good returns, and the lower the risk of losing your money. Young people have time on their side and therefore, generally, a higher risk taking capacity. Of course, other than choice, risk appetite also depends on circumstances and upbringing.
For example, a newly married couple planning to buy their own house cannot afford to lose their savings and hence may be averse to investing in high risk investments.
Investment horizon: The longer you can afford to wait for your investment to generate returns, the more open you will be to taking risk. On the other hand, if money is needed in the near future, a low-risk investment will be preferred. In fact, experts recommend that as financial goals near; switch your money into lower-risk investments, even if it means earning lower returns for a short while. Practically, this makes perfect sense; you don’t want to risk your money just when you need it!
Income and accumulated wealth: It is generally observed that risk taking capacity is directly proportional to your income and accumulated wealth. The higher you earn, or have managed to save, the more capital you have for investing; consequently, the more risk you can take.
Number of dependents: Risk taking capacity is inversely proportional to the number of dependents you have. For example, a young and unmarried person can afford to take a greater risk and rough it out for a while. However, if you are supporting your aged parents, and have to pay for your children’s education, you are much more likely to play it safe.
All of these factors exert some influence on your risk taking capacity. Review your own situation and try to understand where you stand. Another concept that goes hand-in-hand with risk taking capacity is your risk tolerance.
Risk tolerance
Your risk tolerance is the degree of uncertainty you can handle when there is a negative change in your portfolio’s value; in other words, how you react when your investments make a loss. There is a subtle difference between risk tolerance and risk taking capacity. Risk tolerance lies in the mind of an investor and tells us how much risk he WANTS to take as whereas risk taking capacity is the amount of risk an investor SHOULD take keeping in mind the factors discussed above.
Questionnaires available with financial advisors or several tools available on the Internet can help you gauge your risk tolerance. Generally, a panic reaction on every stock market dip reveals a low risk tolerance. On the other hand, if you stay cool as a cucumber, and make the best of every crash, then your risk tolerance is high.
You need to know your risk tolerance before investing because risk taking capacity and risk tolerance determine investment strategy, which requires some self discovery and general financial planning. For example, an older person may be wealthy and therefore have a higher risk capacity; however due to a previous bad experience in the stock market, he may be less tolerant towards equities.
Investment wise risk levels
Now that we have discussed risk from the perspective of the investor, let us look at investment risk. This is necessary because different investments carry different levels of risk.
Equities and Mutual Funds
Equities and related investments, such as mutual funds, carry a high level of risk. At the same time, the graph below shows that equities outclass all other investments in the long run. More importantly, they help you beat inflation and create wealth.
The risk in equities is significantly higher in the short term, when the value of your portfolio depends completely upon the whims of the capital market.
The only way you can avoid this risk completely is by avoiding investing in equities. Hence, investing in equities is essentially an exercise in risk management and risk reduction to a certain extent rather than risk avoidance. Financial products like mutual funds and derivatives are aimed at exactly that.
Debt instruments
This class of investments includes relatively low risk instruments such as government bonds, money market funds, bank fixed deposits, liquid or gilt funds, and so on.
However, seldom are phenomenal results expected from these investments; in fact, many debt instruments offer a fixed rate of return, which often fails to outrun inflation.
Asset Allocation
Creating an optimal investment mix, bearing in mind risk profile and return objectives, is what asset allocation is all about.
When done properly, asset allocation ensures that a portfolio diversifies or spreads the overall risk across investments. A balanced portfolio should include a mix of equities, debt investments, commodities (such as gold), and real estate. How much capital you invest in each investment class depends upon your risk profile.
Financial advisors generally classify investors into the following categories based on investor risk:
- Conservative
- Moderately conservative
- Aggressive
- Very aggressive
The following diagram shows how each category of investors would invest. On the green side are the safer, low risk, low return investments, whereas on the red side are the high risk, high return investments.
Selecting the right investments
The above diagram can be effectively used as a general guideline for identifying how your investments should be allocated. For example, if you fall in the red side, you’ll invest a higher slice of the pie in equities. On the other hand, if you’re playing it safe, you’ll invest more in debt instruments.
As aforesaid, risk taking capacity is determined by investment horizon. Hence how long you plan to stay invested for determines the right investment for you. This is mainly because equities are fairly volatile, and you don’t want to chance your investment value dipping just when you need it the most.
However, regardless of your investment horizon, make sure your portfolio has an equity component to create wealth, and a debt component to protect your capital. Depending on your risk profile it is only the proportion of equity:debt that would vary.
Evaluating your asset allocation
Having identified the optimal investment mix and horizon, you now need to compute the expected average returns on this asset allocation to judge if the selected allocation will help you bridge the gap identified during the financial planning process. If not, you may want to increase the equity component of your portfolio.
If your objective is to create wealth, you cannot afford to invest in low-risk low-return investments. The figure below will tell you why equity investments must form a part of your asset allocation.
Hence, in the long run, returns from equities far outperform all other investment classes. Some allocation towards high return generating investments such as equities and mutual funds is imperative.
Reviewing your risk personality and asset allocation
Life has its ups and downs, circumstances change, and so does your risk profile. Perhaps you were young and single when you began investing, and had a high tolerance for risk. Two years later, you may be married, and the parent of a baby. Suddenly, you may not be able to stomach high risk. On the other hand, you may have come into an inheritance, and suddenly find yourself flush with funds, and therefore more willing to take risks.
Thus, it is important to review your risk profile, and consequently your asset allocation, every once in a while. Experts recommend that you review your situation every six months to a year.
By now, you are hopefully prepared to enter the exciting world of investing; of making your money work for you, and not the other way round. Happy investing!
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