Every investment (equity, debt, property, etc.) carries an element of risk that is unique to it. Though risk cannot be totally eliminated, it can be managed by undertaking effective risk management. To manage risk, you first need to identify different kinds of risks involved in investing and then take appropriate steps to reduce it. As each investment comes with its own unique set of risks, this needs to be matched with your risk personality.

As a general rule, returns generated by an investment move in-sync with the level of risk it carries. In other words, risk and return share a direct relationship with one another. Therefore, an investment which carries negligible risk, will offer a low return (viz. bonds issued by the Reserve Bank of India) while an investment which carries a higher risk, also offers the potential of higher returns (stocks).

While understanding this relationship, you must also bear in mind that though higher risk is normally compensated by higher returns, there is not only no guarantee of such returns but there is the risk of capital erosion as well.

Simply put, all investments are a ‘trade off’ between risk and returns.

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Types of Risks

All investments carry their unique set of risks. Though there are several types of risks, the important ones are - market risk, credit risk, interest rate risk, inflation risk, currency risk and liquidity risk. These are briefly explained below:

1. Market Risk: A share may rise or fall depending on the fortunes of the company, the industry it is in, or in response to investor sentiment. For example, a poor monsoon may dampen investor sentiment pulling down the stock markets or over-production of cement can lead to a fall in cement prices driving down the share prices of all cement companies.

2. Credit Risk: This risk is attributed to debt investments wherein the borrower may default on interest and/or principal repayment. For example, a company borrowing fixed deposits from investors may default on servicing its obligations (interest and/or principal repayment) in case it is going through a bad patch.

3. Interest Rate Risk: When interest rates rise, fixed income investments lose value. This is because the investor will continue to earn the same (lower) interest rate until the investment matures while market interest rates have already gone up. In order to compensate for a lower interest rate compared to the market rate, the fixed income investment will thus have to be priced at a lower rate.

4. Inflation Risk: Rising inflation will erode the value of your income and assets. Due to inflation, the cost of products and services will rise and consequently, your future income and assets will be worth less than what they are worth today. For example, if inflation is 6 per cent, a product worth Rs 100 today will cost Rs 106 a year later. Thus, you will need Rs 106 to buy this product one year down the line which you could have bought today at Rs 100. In effect, one year down the line, Rs 106 will be valued at Rs 100.

5. Currency Risk: Changes in exchange rates between currencies could lead to decline in value of your investments. With Indian investors now being allowed to invest in other countries, you will now be exposed to currency risk i.e. a fall in the value of the currency in which you are investing vis-à-vis your home currency i.e. the Rupee.

6. Liquidity Risk: Certain investments carry the risk of poor liquidity either due to the nature of the asset or regulatory reasons. For example, property is inherently an illiquid investment as it cannot be sold as simply as selling stocks. Certain investments like the Reserve Bank of India bonds are not transferable till maturity. Investments in Equity Linked Savings Schemes are illiquid for a period of 3 years and in case you redeem from such schemes, your tax benefit is withdrawn.

Reduce your risk

Once you have understood and identified different kinds of risks associated with investments you can adopt appropriate steps to reduce these risks. Some of these steps are:

Diversification: Most types of risks can be managed by diversifying your investments across asset classes (stocks, bonds, properties etc.), industries, currencies etc. Diversification spreads the risk and cushions the adverse impact that any one investment might have on a portfolio.

Research and Monitor: Rigorous research and continuous monitoring will go a long way in controlling the market and credit risk of your investments. This will caution you beforehand allowing you to avoid an investment and alert you in case the risk is increasing on an investment already undertaken by you.

Be Patient: Research shows that stock market losses reduce as investment horizons are longer and almost vanish with investment durations in excess of 15-20 years.

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What you need to know about your risks?

Identify your Risk Appetite

To ensure that you are invested in an instrument whose inherent risk does not give you sleepless nights, it is very important to match your risk appetite (risk appetite and risk personality are used interchangeably) with the risk that the instrument carries. In order to assess your risk appetite it is imperative for you take into account several factors – objective and subjective. The former assesses your risk capacity and the latter your risk tolerance. Together they make up your risk appetite.  Hence, your risk appetite will be unique to you.

Assessing Risk Capacity

While calculating your risk capacity, you need to assess factors that are external to you and beyond your control. Age, savings, net worth, number of dependants, stability of job or career and financial literacy will have an impact on your risk appetite.

Assessing Risk Tolerance

Your emotional make-up plays a significant role in how you create your investment portfolio. Intellectually, you may accept that stocks should be a major part of your investment portfolio. Emotionally, however, you may not be comfortable with the sometimes wild roller-coaster ride of the stock markets. Hence, it is imperative for you to analyse your “risk tolerance” level i.e. the level of risk you are able to tolerate and cope up with on a psychological front.

Traits that will help you assess your risk tolerance include your ability to cope with losses, your personality and your attitude towards investment decisions.

Your ability to cope with losses

This is by far one of the most important factors to consider while ascertaining your risk tolerance level. No one wants to lose money or make a bad investment. However, in the event of a loss, you can either feel shattered or you can consider it as a learning experience and start afresh. In the case of the former, your risk tolerance level is low and in the case of the latter, it is on the higher side.

Personality

Your personality comprises of all your emotional qualities and in turn indicates your inherent approach towards investments. For example, some of us are impulsive in our investment decisions while some are more patient and willing to wait for the right opportunity.

Attitude towards investment decisions

The manner in which we invest is an expression of our attitude towards risk taking. Your risk tolerance is high if you equate risk with excitement and you have the drive to achieve better returns by adopting a more aggressive approach. Your risk tolerance is low if you equate risk with ‘fear’ and you are more concerned about not losing your money rather than achieving greater potential returns.

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Risk Personalities

Based on your risk capacity and risk tolerance, you will arrive at your risk appetite. This is the level of risk that you are ready to bear. Once you have ascertained your risk capacity, your risk personality will emerge.

Broadly risk personalities can be categorised at 3 levels – Conservative, Balanced and Aggressive. Each risk personality has a different objective which it aims to achieve through the investment portfolio.

If you are conservative then for you preservation of the capital invested is paramount, even if it means compromising on the returns.

If you are balanced, then you wish to strike a balance between high-risk and low-risk investments.

If you are aggressive, then you do not wish to compromise at all on the returns, even if you risk capital erosion.

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Determine your Asset Allocation based on your risk profile

As you would have now understood, each investment avenue has a different risk and returns level which is unique to it. Furthermore, at any one of point, you will rarely find all investment avenues performing. While one investment avenue might deliver phenomenal returns, another might deliver a low or negligible return. Keeping your investment portfolio concentrated on just one or two investment avenues can lead to an imbalance which either tilts towards higher risks and greater returns or towards low risks and meager returns.  

For example, if 90 per cent of your investment portfolio comprises of stocks, you might gain exceptional returns when the market moves in the direction that you anticipated. But, at the same time your investments will be exposed to a strong degree of risk. If the stock market moves against you, you will not only stand to lose your returns but also the capital that you had invested. The primary aim of spreading your money among various investment avenues is to maximize returns for your preferred level of risk, or to phrase it differently, to minimize risk for a certain expected rate of return. Additionally, it will also lend the much desired stability and liquidity to your portfolio. 

Hence, after having assessed your financial goals and your risk appetite you are now ready to create your investment portfolio using the strategy of asset allocation. In simple terms, asset allocation is the strategy of dividing the investible surplus into various asset classes (e.g. equity, debt, real estate, gold, etc.). Using this strategy will enable you to create an investment portfolio which will help you meet your financial goals, in tune with your risk capacity, the time horizon of your investment and your liquidity requirements, etc.  

Further, individual asset classes are sub-divided into specific instruments. For example, if the asset allocation model calls for 40 per cent of the total portfolio to be invested in equity, you can distribute this across direct equity and equity oriented mutual funds. In the case of the former you can take a spread across sectors (such FMCG, IT, Cement, etc.), across market capitalisation (small, mid and large-cap), etc. In the case of the latter, you can take a spread across equity diversified funds, index funds, sector funds, etc.  

In developing your asset allocation strategy, you should remember that, generally, the younger you are; greater is the level of risk that you can afford to take. As you get older and closer to retirement, you'll probably be less interested in the growth of your portfolio and more interested in capital preservation -- protecting the value of your portfolio from any declines. Preserving your portfolio as you reach your desired retirement age becomes more important since a large decline in the value of your holdings can affect your retirement lifestyle, or even make it impossible to retire according to your plans.  

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Model Asset Allocation Portfolios

Based on your risk personality which is a function of your risk appetite, following are a few model asset allocation portfolios:

If you are conservative

The principal aim of your investment portfolio is to ensure safety of the capital invested. In other words, you do not have the risk personality to take higher risk to gain higher returns. Hence, your investment portfolio will be largely debt oriented. A nominal exposure to equity is recommended to marginally improve the overall returns without taking on undue additional risk.

If you are balanced

Your investment portfolio aims to strike a compromise between long-term growth and safety of capital.

If you are aggressive

Your portfolio seeks to attain growth in the investment value by a higher level of capital appreciation over a long term period.

Remember…

The three sample portfolios discussed above are merely indicative and simply provide a broad overview and perspective of an individual’s asset allocation strategy. It aims at providing a generalised guideline which can serve as a starting point to further customising your allocation strategy.

If you thought that assessing your risk personality and incorporating an asset allocation are a one time exercise during your life-span as an investor, you couldn’t have possibly been more wrong!

As you grow old, there are bound to be changes taking place in your life which would have an impact on your risk personality. These changes could be as diverse as becoming a parent, flourishing in your career or business, facing an unexpected investment loss, etc. When you become a parent, there will automatically be a rise in the number of dependants and a subsequent fall in your risk capacity. If you face an unexpected financial loss, which has made you sceptical of a particular investment avenue, your risk tolerance level will witness a fall.

Since, asset allocation is greatly dependent upon and is directly related to your risk personality, it goes without saying that a re-work of your asset allocation strategy is required when your risk profile undergoes a change. If your changed circumstances enable you to absorb a greater level of risk, you can accordingly increase your exposure to equity and related instruments whereas if there is a sudden fall in your financial health, your investment portfolio can be shifted towards debt based products.

Your asset allocation strategy can also be influenced by the changing conditions in the prices of securities, alterations in the financial markets, economic changes, etc. For example, if there is a continuous upward movement in the stock market indices, you may want to allocate more money into equities so as to gain more profits. At the same time, if inflation levels are rising at a steady pace, you may want to park your funds into securities which give you a better post-inflation return rather than the traditional fixed income instruments whose returns are inadequate in comparison to the growing inflation.

To ensure that your portfolio moves in tandem with changes in your risk profile and changes in your circumstances, you need to undertake a periodic review of the same at least once in a year. This way you can be assured that your portfolio gets re-aligned with your changed circumstances to achieve your financial goals.

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