Deciding what investment is suitable for you is by far the most important and the most difficult question to answer for all of us. And indeed, while there are plenty of wrong answers to this question, there is no right answer.
Choosing asset classes to invest in depends on a lot of factors – such as the risk profile of the investor, the time horizon of investing, the capital available at the current point of time, and the purpose of investing.
While the below article will majorly focus on the risk profiling factor – and the role it plays in investing, let us also quickly go through the other factors mentioned above as well.
Time horizon refers to the period available for the investment to grow. For example, equity investments may be very volatile in the short term and may need longer durations for the volatilities to iron out and give you better returns. Hence, if you are looking to invest for a very short duration, equity investments may not be the right choice for you. You’d rather prefer investing in short-term debt instruments, which though offer lower returns than equity, also ensure the protection of capital in the short-term duration.
Capital Available for Investing
As the name suggests, it refers to the amount of capital that you are willing to invest in the particular asset class and at what time. For example, some people might have a huge lump sum corpus to invest and they may choose to invest in real estate. But this investment option may not be feasible for someone who does not have a lump sum amount to invest but wants to invest a small part of the monthly salary instead.
Purpose of Investing
Yes, the purpose of investing is always to generate more money, but the way you do it might vary. Some investors might invest purely from a growth point of view, whereas other investors might invest from an income point of view. Growth investors would typically invest in equity instruments, while income investors would prefer debt instruments instead. Real estate is a classic example of an investment that can do both growth and income by the appreciation of value and rental yields respectively.
A person’s financial risk tolerance – values, attitudes, motivations, experiences, and preferences are measured through a risk profile. A risk profile helps you understand what type of investor you are, and it is usually done through a series of questions. Since the risk tolerance is calculated using this, it is important to note that the risk tolerance may vary over time for any particular individual, and hence this exercise is to be conducted once every year.
The risk tolerance of an investor can be split into two parts – Risk Capacity and Risk Attitude.
Risk capacity is the ability of an investor to take risks.
This refers to the financial circumstances, number of people earning in the family, number of dependents, security of the income, liabilities, etc. Broadly speaking, an investor with a higher level of wealth or income, and a longer investment duration will have more ability to take risks, leading to a higher risk capacity.
Risk attitude is the willingness of the investor to take risks.
This has more to do with the individual’s psychology than their financial circumstances. Some investors might lose their sleep over the smallest of volatilities in their investments, while others may be more relaxed during the same type of volatilities. This is measured by asking direct questions about possible scenarios of risk and return, and checking your comfort level with the same.
Broadly speaking, investors can be classified into three types basis their risk profiles:
- Conservative Investors
- Moderate Investors
- Aggressive Investors
- Conservative Investors
These investors do not take a lot of risk with their investments. They are typically new to riskier investments and prefer keeping their money in a bank or very safe income-yielding instruments. They may be willing to invest a very small portion in riskier assets if it is better for the long term.
May have some basic experience in investing, including riskier assets such as equities. They understand that a certain amount of risk needs to be taken to meet their long-term wealth creation goals and are likely to be willing to take such risks with a part of their available assets.
These are experienced investors who have experience in a range of investment products and may also take a very active approach in managing their investments. They are willing to take higher risks with a significant portion of their assets to generate higher returns in the longer run.
These risk preferences need to be considered before constructing a portfolio of investments for any investor.
Selection of Investments and Portfolio Construction:
Once the goals and the risk profile have been identified, the investments selected have to balance the required return with an appropriate level of risk.
With investments differing in their risk, return, liquidity, capital requirement, etc, investors have multiple options to choose from while choosing their investments and developing their portfolios.
No one investment can meet all the requirements of growth, capital protection, liquidity, regular income, and high returns. The investor needs to make portfolio-making investments in different asset classes to fulfill the various goals of the investment.
Cash, Bank Deposits, Short Term Mutual Funds
Deposits, Debt Instruments, Debt Funds, Real Estate
Cash, Bank Deposits, Ultra Short Term Funds
Growth and Appreciation in Value
Equity, Equity Mutual Funds, Gold, Real Estate
It is imperative that the portfolio is diversified and contains assets from various asset classes based on the needs and goals of the investor.
For example, investing most of the investments in equity or real estate might lead to liquidity issues in case of emergencies, and you might not have the funds readily available when you need them. Even if the funds are available, you might get a value lower than the expected value of the investment since you will not be able to wait for a good time to withdraw the investment.
Alternatively, having most of your investments in cash or bank deposits will give you the liquidity, but might not help grow your retirement corpus significantly.
Hence, you must plan your investments in such a manner that they are diversified enough to meet your various goals.
Multiplyy is a fee-only investment advisor (PAA), where we handhold our clients for long-term wealth creation by investing in the stock markets. Individual risk profiling ensures that the clients have customized portfolios for their goal-based long-term wealth planning.