A while ago, I wrote about how investing is simple. I also laid out a 5 point plan for managing investments. If you haven’t read it, it’s here. A mere 4 minute read.
Let’s build on that and explore point 1 – “Assess your goals and risk profile” in greater detail now.
All of those who have heard these classic dialogues please raise your hand. Or, well, subscribe to the blog so I know you raised your hand.
- Your risk profile is determined by your age
- Invest 100-your age % of your portfolio in equity
- Just started your career? Make sure you invest in small cap equity funds
- Nearing retirement? Make sure you shift your investments into fixed deposits
- Hello, Devi Prasad ghar pe hai? – Sorry, this has nothing to do with investments! But this blog features Hera Pheri memes and nothing introduces Hera Pheri better than this dialogue. :-p
First, let us examine why goals and risk profiles matter. The key concepts to understand here are
- Return – what you make on your investments
- Risk – what it takes to make returns
Risk is measured in the form of volatility of returns. Think of it as a speeding car. The faster you drive, the earlier you reach your destination. But is it really that simple? The faster you drive, the more prone you are to a risk of accident.
Debt investments (fixed deposits, bonds, debentures, debt mutual funds etc), generally, give stable returns with lower risk. A fixed (or near fixed) stream of cashflows followed by return of your capital. That being said, debt investments are subject to default too – DHFL bonds, Yes Bank AT 1 bonds, Franklin Templeton Debt MF schemes – we have all seen those collapse. However, these are rare events and with discipline you can avoid these.
Equity investments (stocks, equity mutual funds, ETFs etc), generally, give higher returns but come with increased volatility. Cash flow streams are uncertain as well as differ in amount and frequency. Underlying stock prices also fluctuate – some more violently than others and can result in losing capital. That being said, bond prices also fluctuate with changes in interest but that’s a topic for another day.
For now, debt investments – lower risk, lower return, gives surety of corpus and equity investments – higher risk, higher return, generally gives better returns over long horizons.
So, what determines your risk profile?
Age? This is greatly over-rated and over-emphasized because there is some correlation between age and risk profiles. But not as much as one is made to believe.
A young person wanting to save up for their higher education can definitely not afford to have a higher allocation towards riskier investments in the hope of earning higher returns.
A person close to retirement may have enough capital to pass on to their next generation after having achieved all their personal financial goals. Why shouldn’t they invest more in equities to earn a potentially higher return?
Does Warren Buffet, at his age of 90 years have 10% of his wealth in equity and 90% in debt? His equity exposure is a result of the below mentioned factors rather than his age.
Here’s what should be determining your risk profile
- Your future financial goals – the quantum as well as the time horizon towards the goal. The further away your goals are, the more allocation to equity.
- Your emotional quotient – can you enjoy a good night’s sleep without worrying about what happens to your portfolio value when you wake up? Happiness is an important factor in investing.
- Time spent by you analyzing and researching investments – the more time you spend, the higher your conviction and generally, the higher your risk-taking ability and vice versa
So, what is my risk profile?
It is important to understand that risk profiles can only be estimated. Moreover, risk profiles change with time as your situation in life changes.
Your risk profile can be estimated through a set of questions that address the 3 points raised above. Here is an oversimplified way of estimating your risk profile:
|Factor||Tending towards Aggressive||Tending towards Conservative|
|Future financial goals||Largely achieved||Just beginning|
|Emotional quotient||Can tolerate drawdowns. In other words|
– a fall in the markets makes you go
shopping for stocks without worrying about loss of value of existing portfolio
|Can’t tolerate large fluctuations in value of portfolio|
|Time spent on analyzing and researching investments||You love doing this||Ugh, who is going to go through all those numbers?|
The above is only a guide. Of course, there are shades in between Aggressive and Conservative. For eg – moderately aggressive, moderately conservative, neutral etc.
For meme lovers,
Raju is EXTREMELY aggressive. He mortgaged his house and invested in a risky scheme. We all know how that ended. This is an exaggerated example to drive through the concept of an aggressive risk profile.
Shyam is probably neutral, he asks questions about investments and risks, doesn’t like fluctuations in his wealth.
Babu Bhaiya is at the other end of the spectrum. He is being EXTREMELY conservative. At least in this meme.
What does a risk profile mean?
Your risk profile should determine your asset allocation. Here’s a quick table.
|Risk Profile||Allocation towards debt||Allocation towards equity|
|Tending towards aggressive||Less||More|
|Tending towards conservative||More||Less|
Notice how I say less and more and not 0% or 100%. Also, your risk profile is not the only determinant of your asset allocation. Market factors such as valuation, earnings etc also matter but thats a topic for another day.
And if you believe in a proof of the pudding approach, here’s a shortcut – In the previous market meltdowns, how did you act? If you exited, your risk appetite is low. If you added to your portfolio, your risk appetite is high.
Ok, I can estimate my risk profile now but what are financial goals? – Let’s explore that in part 2 of this blog, coming soon.