Understanding Investment Risks before Investing

Brutal fall in Indian stock markets over a period of last one month or so has left most of the equity portfolios bleeding. Fall has been so fast and vociferous that it wiped out almost all the gains of equity mutual fund schemes for last 3 to 5 years and in some cases up to 10 years. People who have started investing from 2018 onwards have their portfolios showing losses in the range of 20 to 50%.

This crash has left many investors wondering whether they were right investing in equity mutual funds?

During my interaction with investors, most of them ask “how much returns they are going to get on their investments?” Return on investments has no meaning by itself unless associated risk is taken into consideration. So the right question should be “how much risk is associated with my investments”. Understanding risk is important so that investors can take a informed decision before investing to get returns commensurate with risk.

Risk Capacity and Risk Tolerance 

More often than not, these words are used interchangeably but they have different meaning all together.

Risk Capacity. It’s the risk required to be taken by the investor to reach their financial goals. Your risk capacity is determined by comparing future cash flows to your investments( how much you expect to add or to withdraw from your investments) to your total value of investments . The more money you will be adding to your investments higher is your risk capacity.

Risk Tolerance. It’s defined as investor’s ability to absorb losses on investments. Low risk tolerance will make an equity investor sell equity investments at the very first instance of it going down whereas high risk tolerance means investor is willing to loose money and hold on to equity investments for potentially better returns. Following factors affect the risk tolerance
a. Time horizon for investments
b. Future earning capacity
c. Availability of other assets like house, pension, inheritance etc

So risk capacity and risk tolerance work together to determine the amount of risk required to be taken while planning investor’s portfolio. 

Investment decisions should ideally be guided by your risk capacity and not your risk tolerance, but often, it is the other way around. Risk return relationship is one of the fundamental laws of finance. You cannot get higher returns unless you take more risks.

The investor with low risk tolerance and high risk capacity needs to understand, that he or she may be compromising on their long term financial goals; on the other hand, an investor with high risk tolerance and low risk capacity needs to understand the potential implications on financial safety of their investments.

How much should be invested in Equity?

Rule of 100. 

Subtract the age of investor from 100, balance number suggests the maximum exposure of portfolio towards equity. e.g if the age of investor is 30 years, maximum 70% of his/her portfolio can be invested towards equities and for an investor of 60 years of age, 40% of his/her investments can go towards equities. These are average numbers and can be taken for planning purposes.

Rule of  Maximum Loss.
 
The Max Loss formula seeks 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 your portfolio that you can tolerate losing in one year?What is the maximum percentage that you think the stock market can lose in one year?The formula of Max Loss % is as follows:

Max Loss %  =  (Max Portfolio Loss + Risk Free Returns) /
                            (Max Market Loss + Risk Free Returns)


Let us illustrate this with an example. Let us assume, you can afford to lose a maximum 5% of your portfolio value in a year and the maximum possible drop in the market in 1 year is 40%. The maximum percentage of portfolio loss should be worked out carefully based on your monthly cash-flows, your short term and long term liabilities and your average liquidity position in determining the maximum loss that you can tolerate.

In other words, if for some reason, you had to redeem your portfolio what is the maximum loss you can afford to bear. The maximum market loss should be based on how much the market fell on an average in bear markets. Let us further assume that you can get a risk free return of 6% (10 years GoI bond yield). The Max Loss % will be (5% + 6%) divided by (40% + 6%). When we do the math, we can have a Max Loss % of 24%. This should be equity allocation in your overall investment portfolio.

 Conclusion
1. Always invest in accordance with your financial goals.
2. Investors with low risk tolerance and high risk capacity should allot a portion of their investments in equity to meet their long term financial goals
3. One should always focus on the risks rather than expected returns. Expected returns are difficult to forecast.

Need to talk more on this? Please feel free to book a no-charge consultation with me on this link.(https://calendly.com/rakeshgoyal). Confidentiality is assured.