Sunday, April 01, 2007

How Much Risk are You Willing to Take?

-----------------------------------------
Series: Beginning Investing (9th post)
Section: Get Started
-----------------------------------------

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

223 comments:

1 – 200 of 223   Newer›   Newest»
Anonymous said...

hey Amit...nice one... so now that u r in NYC..would you analyse the US or the Indian market? ;) ..would luv to catch up with you some time..
arrarrgee (rajesh)

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Can I know your Yahoo ID? Mine is "stockmarketindia24"

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Raj Gopal Vuppala said...

Hi Amit,
I would appreciate if you could post your views on risks associated with midcap and largecap mutual funds.

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Thank You,
Raj

Anonymous said...

Hey Amit,

Nice advice on Nectar lifesciences...But do catch up with how ur reccos work out, Yankee boy

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Hi Amit,
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It will be nice if you could help.

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Anonymous said...

nice article, but the stock market isnt just abt making money.. when big companies lik reliace try to spoil the party then investors tend to loose faith in the market. heres a e.g.
RPL under SEBI Scanner.. the drop from 290 to 195 has been completely operated. thats the news all over.. check this link of financial express and live mint


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Between November 1 and November 6, 2007, a particular group made short sales of 10crore shares of Reliance Petroleum in the futures segment of National Stock Exchange costing Rs.3,000 crores approximately. they made a cool Rs 1,000 crores in less than a month, because the Reliance Petroleum shares have now crashed from Rs.295 to Rs 195 per share!. These guys have made Rs.100 per share.

isnt it ironic that someone knew that RIL was going to sell a huge quantity of shares and the prices were bound to come down?

My 2nd question is Who financed these traders for their margins? Where has this profit gone? and who bore the loss???

Its innocent small investors who bought Reliance Petroleum shares at the high prices, not knowing that this unholy alliance was indulging in insider trading and making illegal profits while Mukesh Ambani's own company RIL was selling shares without disclosing this to investors!!

Naya Investor said...

How should i allocate my money?? From your experience in the field - does the market situation dictate the amount of risk you need to take??

I am also a part of a blog which discusses similar issues. Take a look .
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I hope to hear more regularly from you, I look forward to reading what you have to say!

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Anonymous said...

hi,
really informative.
keep going.........

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Hi Amit, good blog.Excellent summation of risk reward and asset allocation fundas. please checkout my blog on similar subjects at http://www.investologic.blogspot.com. Consider adding a link to it from your blog.

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Do you really believe these should hold for the long term after you know very well about the wall street issues? What will happen after Jan, 20, 2009?

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Is this from your experience. Then, you are very matured. Very clearly written. Keep it up Amit. Awaiting your future updates.

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