Piyush Chopra has been working for two months at his first job. Although he does not have hard and fast financial goals yet, he wants to amass a reasonable portfolio by the time he is 30. His monthly income is Rs.1.3 lakhs and his expenses are approximately Rs. 20,000. He wants to know how to make a financial plan.
Investing may appear to be a simple activity but it is a serious act which requires detailed insights and discipline. Emerging into a successful and smart investor is not easy. It is good to see that young earners like Piyush have set their minds on investing at an early age. The advantage of investing early is the “power of compounding” in the long run. As Piyush goes along in life, his income earning capacity will rise and so will his responsibilities. With age on his side he can consider taking some amount of risk in investment planning. However, before he starts investing, it is important that he understands his risk profile. Apart from ascertaining the risk capacity, Piyush needs to check his risk appetite as well.
Risk is a fundamental aspect of investing. It is important that one establishes the appetite for potential risk before investing any money. Very often individuals jump into investment products which are offered by the investment agents and relationship managers. But a look at the rate of return which is being offered will not give you a clear picture of the risk. In investment, risk remains an important consideration. Although the degrees vary, all investments feature some degree of risk.
Determinants of risk
“Risk appetite” refers to the capacity of taking risk. There are several risk determinants one should take a look into before deciding to invest:
Income: You can use your income to gauge your risk appetite. If your income is high enough you can consider taking risks while investing.
Age: Age too is an important risk determinant. The younger you are, higher is the risk you can take. At a young age you have several years of earning lying ahead of you before you retire. At an early age when you start investing, you can consider investing aggressively and creating wealth over a longer span of time.
Expenses: Expenses can also determine the risk which you can take during investment. You may be having a high income but if your disposable income is considerably less, you will have to refrain from taking risk.
Nearness to your financial goal: If you are several years away from your financial goal you can afford to take more risk. However, if you are not too many years from your goals it is more prudent for you to be risk-averse.
Difference between risk appetite and risk tolerance
Before you take a financial decision, both risk appetite and risk tolerance must be taken into account. Risk tolerance can be defined as the amount of risk an investor is comfortable with handling. Risk tolerance can vary with age and income. Risk capacity or risk appetite on the other hand is the amount of risk which an investor needs to take in order to meet his/her financial goals.
Challenges which investors face
The problem which investors face when they invest in mutual funds is that the risk capacity and the risk tolerance levels vary. The amount of necessary risk which the investor has to take may be much higher than the level he is comfortable handling. On the other hand if risk tolerance is higher than risk capacity the investor can take undue risks.
You must bear in mind that Risk Profile= Risk Appetite+ Risk Tolerance. Investors can be broadly classified into three categories based on their risk profile; aggressive or risk seeker, moderate or risk neutral and conservative or risk averse.
Based on risk profile, following are the indicative portfolio allocations
Aggressive Style – A majority of investments (up to 80%) are to be made in equities or equity-linked instruments that have high capital appreciation potential. The balance may be held in hybrid, debt and liquid funds to provide some liquidity.
Balanced Style – Approximately half of the investments are held in the form of equity investments to generate potentially high returns the rest may be invested in hybrid, debt and liquid funds as well as gold to balance the amount of risk.
Conservative Style – Equity exposure is minimised in order to reduce overall risk in the portfolio. A majority of investments (up to 80%) are to be made in potentially lower risk hybrid and debt funds, while a small portion may be held in liquid funds to provide liquidity.
Before you follow the ideal asset allocation blindly, it is essential that you are well-versed with the different facets of risks involved. Next time you hear or read about an investment opportunity ask yourself whether it suits your style of investing. Investing is all about the risk-return balance you can handle with ease.