Amazon deals

Thursday, December 16, 2010

Risk Management in Investing – a guest post

In last month’s guest post, Nishit had covered the important topic of asset allocation. Without a proper asset allocation plan, investing becomes a hit-and-miss affair. You never know how much of what asset to buy, when to buy and when to book some profit. Often, the end result is missed opportunities and losses.

In this month’s guest post, Nishit covers the related topic of Risk Management. Properly assessing and understanding the risks involved in one’s investment plan and taking appropriate steps to mitigate those risks helps in formulating a proper asset allocation plan to suit one’s individual investment style and risk tolerance level.

-------------------------------------------------------------------------------------------------------------

One of the most important topics that every person who makes any investments should be aware of is Risk Management. A good investor who is poor at Risk Management can get wiped out. Let us try to define risk and risk management.

Any activity you perform in life has a best case scenario and a worst case scenario. The worst case scenario is the risk, and the steps you take to minimise it is Risk Management. In investing, the worst case scenario is loss of capital and returns. The steps for managing risk can be:

(1) avoiding it – e.g. not indulging in day trading

(2) reducing the negative effects - learning the art of setting stop-losses and selling when the stop-loss is hit

(3) accepting the consequences – realizing that to be successful in day trading, a lot of small losses will have to be absorbed

(4) transferring it – buying insurance against trading losses

Risk in investments should be linked to the reward it offers. Risk-reward ratio is the reward which is being offered for the risk you are willing to take. Equity as an investment is risky as compared to investment in government securities, but the rewards are much higher. A 10 year government security will give you a return of 8% whereas investing in blue chip equities may give you 20% annual returns. The G-Sec investment is risk free whereas you face the risk of capital erosion in equity investments.

Risk varies as per the age and the needs of an individual. A 30 year old with a secure job that gives him a steady cash flow can take a higher amount of risk, and a riskier asset class like equity can form a higher percentage of his portfolio. A 60 year old who has just retired may have a larger capital to play with but has no steady income coming from a job. He will need to invest a much higher proportion in debt, giving him a steady income. Also, he has to guard against capital erosion as he will not be in a position to earn back the lost capital from a full-time job.

The table below illustrates the risk-reward ratios of various asset classes:

                     Reward

Risk

High

Medium

Low

High

Mid-cap Equities

Real Estate

Nil

Medium

Gold

‘A’ group Stocks in BSE

Nil

Low

Nil

Good Corporate Debt

Government Debt

Sunil Gavaskar has a favourite saying about percentage shots. He says the batsman has to consider what risk he takes of getting out when he plays a particular shot, and how many runs he scores. Sehwag plays in a very high risk-reward ratio style, whereas Sachin plays low risk shots. In IPL 3, he scored fast but scored mostly in boundaries. This is a classic example of a low risk and high reward strategy.

A good way of protecting your risks is by taking a term insurance cover which has a low insurance premium but high cover in case of your unfortunate demise. The first step of financial planning is to find out how much risk you can take. To play the game, you must remain in the game. In a game of poker, the poker player cannot afford to get wiped out. It is always better to get rich slowly rather than stake all. Twice the government yield of 10 yr paper (8% returns), which will give 16% annual returns when compounded over 10 years will turn Rs 1 lakh into 4.5 lakhs. That is the power of compound interest. Over 25 years, the same amount will turn into 40 lakhs!

Suggested Asset allocation for a 35 year old, considering the volatile state of the markets today:

Asset

% Allocation

Equity

20

Debt

40

Gold

30

Cash

10

-------------------------------------------------------------------------------------------------------------

(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

1 comment:

Joe said...

Real Estate did not figure in the asset allocation. Do you consider any real estate beyond a place to live, not a good investment?

Subodh