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

How Much is Enough?

--- continuing from the last post on Financial Freedom ---

Stage 2 is a tough nut to crack.

First, you need to know what you want out of life and how you expect to be spending your retirement. And this is a question that is really, really tough to answer for two reasons:

1. You've never thought about it
2. Can one really reliably predict what one will be doing 10, 15, 20 years ahead?

Yet this is important, because your entire well-being in retirement depends on it.

Your Provident Fund Alone Will Not Cut It

Till a few years back, it was OK to think that your Provident Fund would take care of your retirement. But things have changed dramatically of late and there is a pretty clear indication of how our retirement options will be a few years hence. In my opinion, the writing is on the wall:

• interest rates on capital protected investments like PF will continue to fall, eventually aligning themselves with market rates. This may not happen now or even in a few years, but definitely soon enough to demolish your PF strategy
• the responsibility for maintaining and managing retirement funds will move away from the government and into your hands
• inflation will eat away into your savings
• your kids may no longer be willing to take on responsibility for your well-being (God forbid, but one never knows)

Given this horror-story setting, it is definitely important for you to know how much money you need to set aside for a happy and fulfilling retirement.

So, How Much Is Enough?

To answer this, at least in a broad sense, try the following:

1. Figure out when you'd like to retire (Be realistic! Chances are, if you are reading this, you ain't gonna be quitting next year!!)
2. Write down your annual budget as determined from your Stage 1 analysis
3. Add in any additional regular payouts you think you might be incuring when you retire and increase the overall budget by, say, 20-30% since you'll probably want to live in better style than you are accustomed to right now. This is how much you would need if you were to retire today. This needs to be adjusted for increases due to inflation till your retirement date
4. Make a guesstimate on how inflation will remain till your retirement, it's better to aim high than low, so perhaps you could take a figure of 6%
5. Calculate the value of your annual payout at the time of retirement by multiplying your retirement payout (from step 3) with (100+inflation)% to the power 'n', where 'n' is the number of years left to retirement
6. This figure is the annual payout you need to keep you retired and happy and should be generated entirely out of investment income. Based on investment returns of, say, 5% you need to have saved about 20 times of your retirement annual payout (from step 5) in order to be comfortable

Example:

You want to retire 15 years from now and your current annual payout is, say, Rs. 200,000. You expect to be spending an additional Rs. 100,000 for annual vacations when you retire and you anticipate inflation to remain at a level of 6% from now till you retire.

Hence, your annual retirement payout in today's money would be about Rs. 390,000 (200,000 + 100,000 increased by 30%). Adjusting it to 15 years from now for 6% inflation would yield an anticipated annual payout of Rs. 934,657 at retirement. (390,000*1.06^15)

This needs to be generated entirely out of investment income and hence you need to save about Rs. 1.87 crores by the time you retire.

Further

Inflation will not end just because you have retired. Hence, the expenses will continue to rise even post-retirement. To account for that, you need to know how long you expect to live (!) post retirement and save even more to accommodate the increasing costs for that period.

But let's not get into that - it's too complicated!

The point of this entire article was that, while retirement planning is an inexact science, it is something you must do so prepare now rather than being taken by surprise when it's too late.

What is Financial Freedom?

I received a very kind comment the day before suggesting that I truly get what 'financial freedom' is about and I suddenly realised that I had never really talked about what that means to me. After all the very idea of this blog is to post about my journey to financial freedom - and yet that has got missed out on the way!

Different Interpretations

I guess there would be different interpretations for different people. Some might say financial freedom is when you have enough money to live off in the style you want and never have to work again. Others would tend to go with a more approachable definition of having enough money to ensure that living and other non-discretionary expenses are taken care of so one is then free to pursue other things free from the worry of paying the next bill. And for those among us who are saddled with uncomfortable amounts of debt, perhaps financial freedom is simply the ability to pay off the loans!

My Two-Stage Approach

I'm looking at financial freedom as a two-stage approach:

1. Lifestyle Maintenance: Save enough to ensure you can meet living expenses from the interest (if you live off the pricipal then of course you'll be back to square one in no time at all!)
2. Retirement: Then look at saving enough to retire and live a happy and comfortable life (again on the interest otherwise your kids might be a little unhappy at inheriting nothing from you, heh heh)

The first is rather easy to calculate - add up or estimate your living expenses per month, extrapolate that into an annual budget and add in any non-monthly expenses you regularly incur in order to determine your budget.

Examples of monthly expenses would be house rent, utility bills, food / groceries, entertainment, fuel, loan repayments, education-related expenses etc. Non-monthly regular payouts would include insurance payments (not an expense but a regular payout that must be accounted for nonetheless), annual vacations etc. Also factor in an anual lumpsum for large purchases that tend to come up every so often like purchasing appliances etc.

Since this will have to be met out of the interest on your savings, you can work out what the savings should be. I'd guess the interest would be about 5-6% on any capital-protected instrument (like perhaps govt bonds) so you need to have saved 17-20 times your annual budget in order to even get to Stage 1 of financial freedom.

It might be tough, but it is definitely possible for all of us. And this calculation will also give you excellent visibility on your spending habits. If you simply cannot figure out how to get to Stage 1 with your current lifestyle, perhaps it might be worth re-evaluating the necessity of some of your expenses.

Stage 2 is another story, though... will get to that in the next post! Till then, please give me your views on the subject.