Risk-Based Investment Planning

August 16, 2012

This article was published in Indiansinkuwait.com on the eve of independence day on 15th August, 2012. 

 

As investors, we are often faced with the situation to deal with our investment options almost on a monthly basis. As a group, we are so varied in terms of age, qualification, salary, and geographical lineage (south India/north India) and this can be seen in our investment habits as well. Regardless of this diversity, frequently all of us approach the question of investment options through the frame of returns. “Can this investment fetch me good returns?” is the question that we ask before we commit money. In many cases, we base our decision based on information gleaned from friends in social meetings. Our investments are also based on our current liquidity position. We invest when we have money and based on what options available at that point in time.

 

Predominantly our investments shall typically include fixed deposits, gold, real estate and equities (stock market). Sometimes we may loan money to our relatives and friends to help them in their studies or business. Over time, we accumulate a variety of investments. I see two problems in this approach:

 

1. Organizing all our investments and regularly following up on how they are performing

 

2.  Ignoring risk while taking investment decisions

 

The first point may sound simple but it is not easy and most of us do a poor job of doing it. It is extremely important to organize all your investments in an excel file apart from physically maintaining all important copies. The job does not end with creating an excel file, the key is to update it periodically (at least once in a quarter if not monthly) and finding out the current value of our investments. These investments are made out of our hard earned income and hence it deserves follow up in order to take quick action on those that are losing in value.  A weekend spent on this is worth the time. Like cancer, most of the investment losses can be avoided by spotting it early.

 

The second problem is more fundamental. All investment opportunities should be categorized based on their risk i.e., High risk, medium risk and low risk. By high risk what I mean here is that the probability of losing all your investment is very high. Medium risk investments may result in loss but not entirely and low risk investments will not result in capital loss at all. However, high risk may also result in high returns while low risk will result in nominal returns and in most cases do not beat the inflation. Typical examples of investments categorized based on risk could be the following:

 

 

Opinions may defer on the classification marginally but not so much that a high risk investment can be felt to be a low risk investments. As you can see, in the low risk segment you may not run the risk of losing your investments while in the high risk investments the risk of losing your investments is very high.

 

Once you have an understanding of this categorization, then comes the key question: How much of my money should I commit to each of the three categories of risk? The answer depends on your age and liquidity requirements. When you are young, you have more time and hence you can afford to take more risk. The reasoning behind this is that even if you lose in value, you have time to ride it out and hope for the recovery. As you approach your retirement, your ability to take risk is reduced and need for liquidity increases. In this stage, you don’t have the luxury of time. Hence, you should initially focus your investments in high risk and gradually reduce it in favor of low risk as you get old. The following chart can illustrate this transition:

 

 

 

For eg., when you are in the age bracket of say 20 to 30 years, your income may be low but your liquidity needs are also low. The amount that you can save every month (after meeting your regular expenses) can be oriented more towards high risk investments like equities. When you move to the next age bracket i.e., 30-40 that is when you need to reduce your allocation towards high risk in favor of low risk. This can happen either by selling your high risk investments (and hopefully you would have made good profits!) and investing them in low risk or by committing your new money more towards low risk than high risk. As you can see from the chart, when you approach your retirement age (typically between 60 and 70) you can see that most of your investments are in low risk income yielding investments since that is the time when you need income to support your retirement. A key opportunity in the medium risk is the real estate. For most people, real estate make up a large part of their total wealth. Buying the first home has sentimental value . Also, one may argue that real estate has no risk since it does not generally depreciate in value. This may be true but most of us buy real estate through mortgage loan running into several years. During this time, interest rate may fluctuate and cause hardships. Also, sometimes if you make a decision to buy a real estate at the peak of the bubble then the price may start stagnating and sometimes fall as well. Hence, it is prudent to consider this as medium risk than low risk. The increased allocation towards low risk as we enter 40’s and 50’s is to make sure that we have enough liquidity to fund the higher education expenses or marriage expenses of our children.

 

As the saying goes, “Trust in God but lock your car!”, prudent planning and follow up of our savings is key to financial prosperity. It is not enough that we work hard and earn money, it is equally important to save them in an intelligent and organized manner fully realizing the risk behind those investments.

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