How Much Risk are You Willing to Take?

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Series: Beginning Investing (9th post)
Section: Get Started
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Hi everyone and thanks for your patience these last couple of months. I'm kind of settled now and hoping to be able to resume my normal posting schedule.

In today's post I'd like to discuss the risk-reward equation that forms the basis for all financial planning (and possibly of life itself, but that's the subject of a philosophical discussion). Essentially, the system is based on the premise that your rewards, or potential gains, are directly proportional to the amount of risk, or potential loss, you are willing to take.

What this means is that you tend to make less money from investments that are low-risk such as government bonds, savings accounts, time deposits etc. These investments are 'safe' and you are extremely unlikely to lose any money except in really extreme circumstances such as wars or suchlike, as a result of which the gains you make are rather low. Typical interest rates would be 3-6%, which is not even enough to beat inflation.

On the other hand, you have the potential to make windfall gains from more risky investments such as stocks and art, but there is a strong possibility you might lose money instead.

Risk in itself is not 'bad'. Because an investment is high-risk does not mean it is a poor investment. The element of risk is just something you should be aware of, comfortable with and able to manage.

Managing Risk and Asset Allocation

Risk can be managed through proper asset allocation i.e. spreading your savings over a number of different investment vehicles (or asset classes) so as to reduce your dependence on any particular one. This allows you the flexibility to settle on a mix of investments that have a risk-reward profile that you are most comfortable with. This would be a weighted average of the different asset classes you select and the way you distribute your money between them.

You should do your asset allocation based on your personal inclination (e.g. some of us are inherently more risk averse and conservative than others), stage in life (e.g. someone nearing retirement would typically be more conservative than someone in his early thirties) and financial commitments (e.g. you would want your basic living expenses to be coming from a secure and dependable source such as a savings account). Ideally try to get help from a qualified financial planner who would be able to take you through a series of questions in order to identify the best risk profile and asset allocation for you.

Rough Guide to Risk-Reward for Different Investments

As a rough guide, here are the kind of returns you could expect from different forms of investment. The classifications are mine, I don't think there is any standard form of classification used generally:

• Low Risk (very low probability of losing money) e.g. savings accounts, government bonds, time deposits, gold): 3-6%
• Medium Risk (some chance of losing money, especially when buying in an overheated market) e.g. real estate, gold: 6-10% long term
• High Risk (significant chance of losing money, markets volatile) e.g. mutual funds, REITs: 10-15%
• Very High Risk (strong chance of losing money, markets highly volatile) e.g. sector-focused equity funds, individual stock picks, forex, art, hedge funds: 15-30%

The above might seem a little on the low side, especially given the kind of returns we have seen in the real estate and stock markets, but I believe these should hold for the long term.

Your personal portfolio returns will be an average of the returns above, based on your asset allocation.

Next Post on Beginning Investing: Asset Allocation and Investment Maturity

Moving

Hi everyone,

Hope you are all doing well.

I'm moving to New York in a few days and have been really tied up with work and preparations for the move, which is why I have been unable to post for a while now.

Give me another 2-3 weeks to get everything sorted out and then will be back with some new material.

Thanks for your patience and do keep coming back!

Set Aside Emergency Cash

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Series: Beginning Investing (8th post)
Section: Before You Invest
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Now that you have productively used your monthly savings in reducing your debt and purchasing adequate insurance, there is one last thing to take care of before you move on to investments - setting aside emergency cash.

Though the risk of losing your income is low, life is uncertain and any number of things may come up to disrupt the normal course of things and force you to take a break from your job. It is also possible that you may need extra cash to handle an emergency or just to take advantage of an unexpected opportunity.

For such situations, it is important to have a cash buffer. The amount you set aside is up to you, but given the primary purpose of having sufficient liquid funds to tide you over in case you lose your income, I would suggest the minimum you set aside should be enough to cover 6 months of regular expenses, as determined based on your expense analysis earlier.

These funds need to be readily accessible and risk-free, and hence should be kept in a bank account and not as a fixed deposit or in high-risk investments. You may not earn much from this money but that's not an issue.

This concludes the section on things to take care of before you invest. The main purpose of these last three posts was to ensure a fallback plan for you and your family in case of trouble, a conservative approach that will allow you to invest your money secure in the knowledge that you have provided well for the people that depend on you.

Next Post on Beginning Investing: How Much Risk Are You Willing to Take?

Insure Yourself and Your Property

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Series: Beginning Investing (7th post)
Section: Before You Invest
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Today's discussion will be on the next important thing to tackle before you start investing - Insurance.

Generally speaking, most of us equate insurance with savings, treating it as an investment mechanism. This midset is reinforced by the tax rebates we get on insurance, encouraging everyone to invest more and more in high-premia endowment plans every year in order to avail of the tax benefit.

However, the main purpose of insurance is to mitigate risk - risk of death (life insurance), risk of loss (general insurance), risk of illness (medical insurnace) or risk of untoward incidents while travelling (travel insurance).

As an individual, and a responsible householder, you should cover all of these risks when you plan your insurance, rather than rushing off to purchase more life insurance just because you get a tax break!

How Much Insurance Do You Need?

This is a fairly straight-forward question to answer:

• Life Insurance: The conventional approach is to insure yourself for an amount equal to about 10 times your annual income, which is a truly staggering sum! However, I believe this is a better way of looking at it. I also subscribe to the concept of layering your insurance plans so that you can increase your insurance amount over time till a point, after which it starts to reduce because you have saved a good amount by then and might not need so much insurance
• General Insurance: Insure your house (an option that generally is offered with many home loans nowadays - go for it) and your valuables. Burglaries and other mihaps happen and you'll sleep much better knowing that you have a fallback option. There'n no reason for you to learn this the hard way as general insurance premia are really low and definitely well worth the benefit!
• Medical Insurance: In general, try to get yourself and your family covered for major illnesses and surgeries. Some banks, such as Andhra Bank, offer a floating cover that can be shared by the entire family, which I think is a very useful facility as it saves the trouble and expense of insuring each family member independently
• Travel Insurance: This is a must while travelling. If you are abroad and things get stolen, your personal funds will not really help much, I can tell you!

A Bit on Life Insurance

There are two basic kinds of life insurance policies: endowment, wherin it is a risk cover cum saving scheme (this includes money-back policies, unit-linked insurance etc) and term assurance , which is a pure risk cover. The returns on your investment in the former are generally worse than you can do with other comparable investments in the market so I'd always recommend term assurance as the best form of life insurance. It has the added advantage of having very low premia because you need not invest anything in savings. However, due to its nature, the entire premium is an expense. Once you pay it, it is gone and you will not get it back unlike in an endowment policy.

Next Post on Beginning Investing: Set Aside Emergency Cash

Real Estate Prices - Chennai

The following is a piece contributed by Raheja Assoiates, one of the premier real-estate brokers in Chennai.

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The real estate market in Chennai is on the upswing thanks to the IT Boom and the number of manufacturing industries preferring Chennai as their destination point. A number of new companies such as Flextronics, Nokia, Motorola etc. have chosen Chennai to set up their factories. Along with them, a number of subsidiaries have also come into Chennai. This has helped the real estate industry to grow from within the city limits to the outskirts.

Some of the fast-growing areas where one could think of an investment are Sriperumbudur, Maraimallai Nagar and the IT Corridor (Old Mahabalipuram Road). The land prices in these areas have more than doubled in the last six months . One could also think of an investment on the East Coast Road close to the sea but beyond the 500 meters guideline.

Some of the prevailing prices for brand new apartments in the prime areas are:

• Boat Club Road: Rs.12000 to 15,000 per sq.ft.
• Poes Garden: Rs. 10000 to 12,000 per sq.ft.
• R.A.Puram: Rs. 7000 to 7500 per sq.ft.
• Harrington Road: Rs. 7500 per sq.ft.
• Adyar: Rs. 5500 per sq.ft.
• Kilpauk: Rs. 5500 per sq.ft.
• Thiruvanmiyur: Rs. 4500 to 5000 per sq.ft.
• IT Corridor: Rs. 3200 to 3400 per sq.ft.

For further information please contact Raheja Associates at www.rahejas.com.

I hope this article will help those of you seeking to make investments in property. Do you think I should make it a regular feature? Please leave your comments to let me know.

Have a Wonderful 2007!

A happy new year to you! Hope 2007 brings you peace and prosperity and takes you several steps onward in your journey to wealth and financial freedom!