What is your Risk quotient?, Understanding our risk capacity

Most of us wants certainty in life and risk is actually the uncertainty on the outcomes. Risk as defined by several people is “The chance that an investment's actual return will be different than expected. Risk includes the possibility of losing some or all of the original investment.”  So are we risk averse or ready to take the risks? The answer to this question is often determined by our own personality. Some people, by nature, want to play safe; as they do not want to lose their sleep over the prospect of losing money. We can call them risk averse person. On the other hands there are people who are aggressive, they are motivated by prospect of making money rather than the risk of losing it. They are called the risk takers.

Out behaviour is driven by fear and greed and these two emotions determine our risk taking behaviour. Further Risk taking behaviour may not always remain same it can change over time. For example, in bear markets risk aversion is seen to increase whereas in bull markets risk taking increases. Risk appetite can also change with change in personal situations. Willingness to take risk is known as risk appetite. However, willingness to take risks may or may not be correlated with the person’s ability to take risks. For example, a 23 year old young professional with good income and no liabilities may have low risk appetite, even though his ability of taking risks should be high on the other side a person in his 50s is comfortable to take risk. The ability to take risks is known as the risk capacity of an individual.

There is very clear difference between risk appetite and risk capacity. Our investment decisions should ideally be guided by our risk capacity and not your risk appetite, however generally it is the other way around. Risk return relationship is one of the fundamental laws of finance. We cannot get higher returns unless we are ready to take more risks.

·       An investor with low risk appetite and high risk capacity needs to understand, that he or she may be compromising on their long term financial future;

·       An investor with high risk appetite and low risk capacity needs to understand the potential implications on financial safety.

In this post we will try to understand how investors can measure their risk capacities and put it to practical applications in their investment decisions.

1.   Rule of 100 for Asset Allocation

This is a very popular asset allocation formula for measuring risk tolerance. Simply put, we should subtract the investor’s age from 100, and the result suggests the maximum percentage amount of the investor’s portfolio that should be exposed to equities. So for a 30 year old investor, this rule suggests that 70% of his or her portfolio should be invested in equities, and for a 50 year old investor, this rule suggests that 50% of the portfolio should be invested in equities. However we should understand that, this formula, is a simple practical methods, not guaranteed to be perfect or optimal, but on an average, gives sufficiently good results. One criticism of this method is that, since average life spans are increasing, this rule may not give sufficient equity allocations to retirees and therefore may fall short of meeting the cash flow needs of the retirees through their lifetimes, especially in high interest regimes. Some financial planners believe that these days, Rule of 120 is more effective.

2.   Maximum Loss Rule

The Max Loss formula try to help investors determine the maximum percent of their portfolio that they should expose to equities. Max Loss depends on two factors:-

·        What is the maximum percentage of our portfolio that we can tolerate losing in one year?

·        What is the maximum percentage that we think the stock market can lose in one year?

The formula of Max Loss % is as follows:

Let us understand this with an example. Let us assume, you can afford to lose a maximum 10% of your portfolio value in a year and the maximum possible drop in the market in 1 year is 30%. In other words, if for some reason, a person had to redeem his portfolio what is the maximum loss he can afford to bear. The maximum market loss should be based on how much the market fell on an average in bear markets. A bear market is usually defined as the period, when the market fell by more than 20% from its high. Remember that, this is simply our expectation of maximum market fall percentage. One can never forecast how much the market will fall in a bear market. Let us further assume that we can get a risk free return of 7%.

In this case the Max Loss % will be (10% + 7%) / (30% + 7%). Accordingly Max Loss in % comes to 45.9%. Hence this should be equity allocation in our overall investment portfolio.

The maximum percentage of portfolio loss should not be an ad-hoc or whimsical number. We should factor in our monthly cash-flows, short term and long term liability situation and average liquidity positions to determine the maximum loss that we can tolerate on a particular situation.

3.   Time Horizon for Investment

Time horizon for investment is one of the most important factors in determining risk tolerance. The longer is the investor’s time horizon greater is his risk capacities. We should look at our investment goals and determine the time horizon for accomplishment of these goals. Longer the investment time horizon, higher is the risk capacity. This is because, volatility is a bigger risk in the short term than in the long term. Although there are no hard-and-fast rules, following are some general guidelines that can investors decide which investments types are suitable for various investment tenures.

         i.  Very Short term:

 Generally, term horizon of less than 2 year can be called as very short term horizon. Fixed income products are the most appropriate asset class in the short term. Short term can further be sub-divided in different investment tenures. Debt mutual funds i.e. Liquid/short term debt funds offer good solutions for variety of this investment needs.

       ii.  Short term:

 Short term horizon can be defined as 2 to 5 years. Fixed income along with some equity portion can be appropriate asset class in the short term. Balanced funds with conservative equity portfolio can be an ideal asset class in this investment part.

      iii.  Medium Term:

 Generally, medium term is 5 to 10 years. In this time horizon risk capacity is higher in medium term and therefore we can take little higher exposure to equities, to get higher portfolio returns and meet your investment goals. Hybrid investment with higher equity exposure can be ideal option in the medium term. Balanced mutual funds with aggressive equity portfolio can be excellent medium term investment choices.

      iv.  Long Term:

 Long term is a period which is more than 10 years. During this period our risk capacity is the highest. A long time horizon allows our investments to recover from temporary losses and create wealth for through the power of compounding. Equity is the best asset class for long investment tenures. Further within equity as an asset class, based on the risk appetite, we can take some exposure to small and midcap stocks (through small and midcap equity mutual funds) if our investment horizon is long term.

4.   Psychometric Risk Profiling

Many investment portals use psychometric risk questionnaires to profile an investor’s risk capacity. Investors are asked to answer a set of multiple questions and the answers to the questions help in evaluation of the investor’s risk tolerance. This can be done with the help of professional Advisers to get the right portfolio allocation based on individuals own profile and risk capacity.

Investment Success plan for Young Professionals

Current around 60% of the population in India is young below 35 yrs age and they are the ones who are actually running the whole economy. They are the major contributors to the GDP and also are the current and future leaders of the nation. While everyone is considering them to be instrumental to the success of this country, there are concerns about what makes the young generation successful financially and how to do it.

The changes in the job sectors and high growth in the employment by private sectors, the financial power of an individual is significantly higher in the hands of younger people as compared to few decades back. However the spending patterns for them has also changed along with this high income, buying consumer durable items (electronic gadgets), eating out and shopping is not a rare phenomenon anymore, rather a common weekend activity. With such sharp changes in lifestyle we increasingly miss out on an old school thought, the emphasis on savings. The tales of youngster being in debt and depending upon credit cards is becoming a common phenomenon. Hence, the old habit of savings is slowly being replaced by overspending. In such a state, we need to think about why despite having more financial ability we still suffer from lack. ‘Enough’ is not a commonly used word and this points to an unfortunately common phenomenon of the lack of savings and investment.

There are people who despite starting the months with good money in account left with hardly any money at month end. Sometimes despite being serious about savings we are unable to save, and the intentions are often not reflected in the action. Why is this generation not being able to save and invest successfully? A miniscule percentage in our country invests. A simple change in lifestyle could possibly change this habit. Let us see what steps can be taken to make your investment journey a success.

1.   First asses the Income and Spending

It is essential for anyone to know how much he is earning. The distinction between gross income and net income should be clear in the mind of everyone. Gross income is the salary from which tax deductions, and contributions to Employees Provident Fund is made. The balance is known as the net salary or the salary we take home. After that we should asses how much we are spending we can do it by keeping the shopping bills, credit card bills and checking the list of transactions on the net banking account. After that we have to decide about savings, the basic way to save is by analysing how much we spend and the avenues of of expenditures. Then we should try to identify the areas where we can cut down and slowly start savings. Simply speaking, total spending deducted from net income is your savings. Hence, if we don’t have any funds at the end of the month, we need to start figuring out our spending habits and start saving.

2.   Define the Goals

Saving without goals is like a journey without destination. Goals are milestones/destinations in life which we wish to achieve for personal gratification. To be able to make a list of goals, the best and probably the most effective way is to put the goals along a timeline. Goals can be defined as:

• Short Term Goals: These are goals that have to be achieved in a short span of time say a year or two years. These are goals for which we may need money immediately.
• Intermediary Goals: These are goals that are a little further away. There is still time left for investments and wait for the returns to generate a decent corpus. These goals could be five years or seven years down the timeline.
• Long Term Goals: These are goals which are usually to be achieved at an advanced age like retirement or goals set out that you wish to achiever after ten years, or fifteen years or even further.

Once we have decided about our goals based on the above mentioned three broader timelines, we can start planning our investments based on these.

3.   Find Out Your Total Savings

Savings means the money that is lying idle or in savings accounts for more than six months and is not being utilized to generate returns of any kind. We can collect all the money and get a definite number on your total savings. If we are been working for a few years now and only have few thousands in the account means not very good sign. The amount we save speaks about our finances more than our net earnings. Hence, it is time we should took an assessment of our savings and see where we stand financially.

4.   Know Your Investment Needs and Risk Taking Ability

Another important aspect that defines our investments is our risk taking ability. There is nothing wrong in being careful or even wanting to make profits. In most personal goals it is seen that calculated risk is an essential component to generate returns and facilitate the growth of the corpus. The everlasting question a lot of investors ask is, does the risk determine the investment need or the investment need determine the risk. Let us consider a scenario where our personal goal is buying a house in the next five years. It means we might need a big corpus and traditional method of investment may not going to be enough. In this scenario, investment in stocks or equity mutual funds becomes necessary to give that extra boost. We should not let our risk taking ability be a hindrance to your investment needs; however we should avoid having unrealistic expectations and taking unnecessary risks.

5.   Have a Proper Investment Plan

A proper investment plan is a comprehensive map which shows how the money is being channelled into various investment instruments. Investment plan also becomes our personal guide which tells us regarding various due dates for investments i.e. when the insurance premiums have to be paid, or monthly date for Systematic Investment Plans (SIPs). As an investor we can make our own investment plan. However, seeking a financial advisers help may give a better and holistic approach for investments.

6.   Cover for Life and Health: It’s very Important

We can fulfil our financial goals only if we live a healthy life. However, we cannot get so optimistic that we ignore the inevitable death. Get a term plan based on earnings which gives sufficient coverage of as long as 70 - 75 years at least. You can get a higher term plan or have a greater coverage in the same term plan once our income increases. If we are switching jobs and your new organization does not provide insurance facilities then we may have to increase the coverage or if we  are becoming an entrepreneur then we must increase our term plan. we could also look into family floater options  for health insurance that covers an entire family for a stipulated premium.

Insurance not only covers us for health but it also protects our family in case of an untoward situation.

7.   Start Your Retirement Planning

As investors we tend to ignore the long term goals. Ignoring the goal of retirement planning can be the biggest mistake and cost dearly at the time of no regular earnings. This corpus is to support us during the retirement days. Hence, planning for it is absolutely crucial. We do not have to start investing lump sums at an early stage because we will have other goals to focus on. However, a small sum invested every month through SIPs could take you far. Just disciplined investments, even if they are small sums could be enough for a retirement corpus.

Hence, start retirement planning and do it now.

8.   Emergency Fund is for Emergencies

An emergency fund is what we will rely upon when we have to tackle a difficult financial situation that was not anticipated. An emergency fund should consist of 3 to 6 months of monthly income. The key to having an emergency fund is easy access to funds without disturbing ongoing investments. Hence, we should not invest the corpus for emergency fund in instruments that have a lock up period such as Equity Linked Savings Scheme or fixed deposits. Liquid funds in Mutual funds could be a good option for such corpus where we can invest for as less as a week. A successful investment plan must include an emergency fund so that despite adversities we can lead a well-planned life and the corresponding investments continue to run smoothly.

9.   Rebalance and Readjust Your Portfolio:  It’s an ongoing process not just one time

Making an investment plan is an ongoing and continuous process we should not think it as a onetime thing. Investments are instruments that have to be changed based on our needs and time. The investment plan that was ideal when at the starting may not be the same when the investors are middle aged and at the peak of their income. An investor in their 60s will have a different investment plan than an investor in their 20s. A successful investment plan is that which is reviewed and boosted periodically.

.                 10. To Conclude

The young generation is the backbone of the country as well as the economy. They represent the present and the future of the country. This young generation has to ensure that they, the driving factor, are also driven by the right objectives. As professionals one should and must enjoy their lives and grasp all that life has to offer. However, it should not come at a heavy cost to our future needs. The young generation should become aware about the investing options and slowly the wave should change from savings to investments.

Interest rates and Equity Market!! What is the relation??

Over the past few years we had witnessed a number of events which caused jitters in equity markets globally, namely the Greece Debt Crisis, Brexit, China economic slowdown and Yuan devaluation, and recent surgical operation by India. But still the stock market players have night mare of US fed rate hike and its implications in Mid 2013 even the hint of that make lot of sell of in the equity market. In this post, we will find out the relationship between interest rates and equity markets and try to understand that why markets are happy when interest rates are cut and why they are nervous when interest rates are expected to rise.

As we all know, Interest is the cost paid by the borrower for using the money of the lender for a specified period of time. We borrow money to spend on something; if we don’t have to spend, we will not borrow. Therefore, when people borrow less, it means they also spend less. Let’s also understand that what is spending for me is an income for the other person by whom we are purchasing.  

For example, if borrow from a bank to buy a car, the car manufacturer get income from the sales made to us. Now lets say if interest rate for loan is high only those who are in desperate need will borrow to buy a car and as the rates falls more and more people might be interested to take a loan for purchasing a car. Hence low or high interest rates provide incentive or disincentive to borrow. Therefore, low interest rates will result in more sales for the car manufacturer, while high interest rates will result in less sales for them. When sales increase, profits and share prices of the manufacturers increases; when sales decline, profits and share prices of the manufacturers falls. The impact of interest rates are more prominent in Auto, Real Estates, consumer durables and have less impact on consumer essential items.

What applies to a consumer also applies to companies. When interest rates are low, companies will borrow more to expand their capacities, which in turn can lead to higher sales. On the other hand, when interest rates are high, the company will refrain from borrowing and spending on capex. If a company is operating at low capacity utilization, it can increase sales by simply improving its capacity utilization. But if the capacity utilization is high, the company will not be able to increase its sales, unless they add more capacity. To add more capacity, companies need more money, but if interest rates are high, then they will be hesitant in borrowing money and as a result, will give up on higher revenues and earnings. Interest rates will have an effect not just on the manufacturer but across the supply chain. If the manufacturer is producing more, it will buy more from its suppliers; if it is producing less, it will buy less from its suppliers. Interest rates also affect the distributors or dealers of the manufacturers. That is why markets react positive to news of interest rate cuts and negatively to news of interest rate increases.

Central banks around the world (including RBI) have two main concerns with respect to interest rates; the effect of interest rates on inflation and the effect on GDP growth. Both these effects are inter-connected and therefore, the central banks have to maintain a careful balance between the two. As mentioned above lower interest rates stimulate demand for goods. But this higher demand leads to higher prices. Since Inflation affects the poorest sections of the economy the most. Central banks (including our RBI) have the responsibility of protecting the weaker sections of the economy from price rise, and they do it by adjusting interest rates (the Repo Rate in case of India, the Fed Funds rate in the US).

Interest rates changes also affect behaviour of investors. Rise in interest rate causes a flight to safety, because safer fixed income investments, like Bank Fixed Deposits, Government bonds etc become more attractive investment options relative to equity. Fears of interest rate increase also cause the yield curve to flatten out; flattening yield curve increases uncertainty and with increase in uncertainty, equity investors will demand higher risk premiums (if we are taking more risks, we demand more returns). Although in this scenario investor demands higher returns, the earnings or cash-flow projections of companies don’t change; In fact it can worsen for companies in rate sensitive sectors. The mismatch in risk premium and the fair value of the company (in terms of cash flows), will lower investors demand for stocks and will, therefore, affect stock prices.

However the impact and behaviour as mentioned above is of short term and in long term there are various other factors which may have impact on interest rates and equity market. While interest rates certainly have a role in stimulating GDP growth, GDP growth is caused by higher per capita income, improved productivity, capital and man power available for production, ease of doing business etc. Higher GDP growth will inevitably result in higher inflation, for which the central bank (RBI) will have to increase interest rates, past data shows that, GDP growth can be restrained somewhat, but not reversed, by higher interest rates.

If we look at the Indian economy, from 1996 till 2004 (See the chart below) interest rates fallen significantly but there was hardly any movement in equity market. In the early and mid-2000s, right up to 2008, equity market went up by four times and we had high GDP growth however interest rates were also rising during this period. In 2008 post Lehman crisis market fell down steeply and recovered half of it in a year after that till 2013 both equity market and interest rates were almost stagnant. Now since 2014 interest rates have fallen and equity market has gone up during the period. 

Since March 2016 the equity market has recovered considerably. However there are serious concerns about interest rates globally, especially in the US which may start hiking the fed rates post US elections. But it may have a short term impact on equities, by reducing liquidity available for equities. From a longer term perspective, increase in US interest rates means US economy is strengthening and does not need the monetary stimulus. As US the biggest and consumer driven economy, its growth will lead to demand from emerging economies like India. Further higher income to US companies will also lead to more investment in emerging markets like ours. Hence it may not be such a bad news for long term equity investors; on the contrary it is good news.