Understand THESE RISKS before investing in stocks

Investing in equity markets to earn a good return over long term is not a cakewalk. One has to understanding her/his risk profile and importance of asset allocation to achieve financial aims

Every investor aims to generate maximum returns from investments. However it's always recommended that an investor evaluate one's risk profile before taking investment decisions.

'Asset allocation' primarily aims to reduce the overall portfolio risk by investing in different financial asset classes such as equities, bonds and cash. For investors, thus it is always an effective tool to reduce overall risk. Asset allocation is significant because it will have an underlying effect on whether you will meet your financial goals or not.

The decision on how much risk to take, and what type of risks to take, is critical to success of your investments. If you don't include enough risk in your portfolio, your investments may not earn enough return to meet your goal/s. And playing too safe with your investments can adversely affect your returns.

A simple way to check your risk tolerance is to ask yourself how much comfortable you are in taking risks. For instance, if changes in your value of savings and investment keep you fidgeting and worried, or your instinct is to sell your investments every time market tanks, then you may want to shift to more moderate investment mix, such as fixed deposits or traditional life insurance.

For instance, it is always recommended that if your goal is long term (say 15 to 20 years down the line) such as retirement or child's higher education or marriage, equities is recommended asset class to generate decent returns over long run otherwise you won't be able to amass enough savings for their retirement, leave alone other crucial financial goals such as child education and child marriage.

On the other hand if you take too much of unnecessary risk, you may incur huge losses and thus in turn lose capital which you would have invested. For instance, if you are an individual who earns well but has irregular or lumpy income, you need to be bit cautious and should keep 3 to 4 months expenses in liquid assets or in a savings bank account and reduce your exposure to equities accordingly.

If you have a lot of assets and have minimal responsibilities, your allocation can be skewed to equities. As you develop liabilities -- home loans, college education for children, marriage savings -- you have to understand your required cash flows and skew your portfolio towards debt.

Your age, industry type you work in, variability of income, your liabilities, dependents you have and your current investments broadly are the key factors which affect your ability to take risk.

An asset allocation thus boils down to following significant factors so as to achieve right balance...

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Courtesy: Investment-mantra.in

1. Investor's age

This is the most significant factor. Young people can take more risks than those nearing retirement. For those who are retiring the aim is to protect capital. Start investing early is the key point here. Basic rule here is that you subtract your age from 100 and that is the percentage you should invest in equities. So for instance if you are a 30 year old, you can invest 100-30 = 70 per cent of your money in equity and equity oriented mutual funds.

2. Risk profile of individuals

Risk profile plays a significant role in deciding percentage allocation to different asset classes. Some individuals are comfortable with taking risk but there can be individuals even in their 20s averse to take risk.

There can also be situations wherein an individual is servicing a loan or has a large family to support. In such a scenario one should be bit more careful if investing directly into stocks. In such a scenario a substantial emergency fund is a must. So asset allocation needs to be defined accordingly.

For instance, an investor having fairly good knowledge of equities may invest 80 per cent of his/her portfolio in equities and just keep aside 20 per cent for investment in bonds and cash. It is very much possible an individual of same age may invest only 50 per cent of his/her portfolio in equities and keep remaining 50 per cent in cash and bonds.

Risk profile can vary according to the goals an individual has. Since all investments are meant for an individual's specific goals, each has its own risk tolerance and specific time frame. A person whose retirement is 30 odd years away can take some risk than one who is accumulating for one's marriage next year. So in nutshell, objective of the investment and the time available to achieve it determine the risk one can take.

Lastly, since asset allocation is related to your age too, so it's a dynamic concept. As you grow older, you should re-jig your portfolio to suit your time horizon. For instance when you are 25, you can afford 75 per cent of your money in equities but maybe at 35, you need to modify your asset allocation a bit.

Another instance can be where a 70-year-old retiree should ideally not invest in stocks and equity funds. But these can be perfect option if s/he's investing for her/his grandchildren.

Another instance where you need to re-jig your allocation is when percentage of one asset class goes beyond a limit because of market fluctuation. For instance, if your allocation to equities is 60 per cent and it has now gone to 80 per cent during bull market phase, you can evaluate selling some of the stocks to get it at comfortable level or buy more of other asset class to balance your portfolio.

Bottom line is that before you plan your investments, evaluate your risk profile and decide on suitable asset allocation. Once done, then zeroing on best investment opportunities within the respective categories. Choose the right mix of equity, debt and cash. Make sure you have an emergency fund in place so as not to poke into your money meant for long term goals. Never touch the emergency fund for investment. Remember evaluating your risk appetite is the first step towards making a meaningful financial plan.

Make sure post this write-up you completely understand that evaluating one's risk profile and doing asset allocation accordingly is the most important decision that one makes with respect to his/her investments.

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Mr A is 30. His monthly income is Rs 52,000 with no liabilities and relatively stable job in a leading financial firm. He invests only 20 per cent of his investments in equities. Rest of funds flow into safer fixed deposits. Given his age, stable income and no liabilities, Mr A can be moderately aggressive whereas he's currently moderately conservative.

It is understood that some investors are hesitant to invest in equities but surely they can do a bit of research and take a mutual fund route to invest in equities, maybe begin with a balanced fund.

a. Conservative: Capital protection is the aim even at the cost of sacrificing returns. Fixed deposits, post office schemes are the best options.

b. Moderately conservative: Utmost 20 to 25 per cent allocated to equities and rest is in debt. Capital protection over medium to long term is the aim.

c. Moderate: 50 to 60 per cent debt investments and 40 to 50 per cent in equities is the right mix here. Reasonable amount of risk can be taken in exchange of better returns for the investments.

d. Moderately aggressive: Above average risk can be taken with investing up to 70 per cent in equities in lieu of very good returns over long term.

e. Aggressive: Allocating 80 to 100 per cent of funds into equities is what makes it aggressive. Make sure high risk doesn't mean reckless investing here. While in short term there can be some notional losses but long term picture is promising.

A mutual fund with a good 15-year track record is a worthwhile bet. Whether to hold large caps or mid caps is also an important question, and in general 70 per cent large cap, 20 per cent mid cap and 10 per cent small cap is a good starting point, for a moderate risk appetite.

Finally, equities and debt don't make a complete portfolio, and most investors either under allocate or over allocate to alternatives. Alternatives include gold, other commodities, structured products, international equities, private equity, hedge funds/absolute return funds, and real estate funds.

While stock picking and market timing appear to be the more glamorous parts of investing, for an investor looking for consistent increase in her/his wealth with moderate risk, asset allocation provides a time tested, simple and cost effective answer.

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