When one invests, he/she tries to analyse the risk involved, but doesn’t benchmark the expected returns against the risk. If one does that, he/she will be able to better evaluate the future performance and decision on investments. It makes sense to assign expected returns to monitor your investments better.
The concept of risk-reward is same for all types of investment. But there are scores of investors who don’t understand how to apply the concept of risk-reward to their portfolios. If you are one of them, read on.
Whenever you invest there is a risk (high or low), that you might not get your money or the returns on it (partially or fully) depending on type of avenue. For the risk that you bear, you expect a return. Typically, higher the risk you take, higher should be return you receive for holding the investment and similarly lower the risk, lower should be the return you receive.
expected return* (%)
||8.5 – 9.5
|Post office products
||9.5 to 11
||15 – 20
|Equity mutual funds
||15 - 20
||20 - 25
|*Data based on historical trend; avg over 3 to 5 years
Know your risk appetite
Every individual has a different risk perception. It’s difficult to create a model applicable to everyone. There are two aspects to decide how much risk you can take.
Time horizon: Before you make any investment, know the time you have in hand to stay invested. Say you have Rs 5 lakh to invest but you can wait only for a year (because you need the money to pay for your new house), don’t invest in equities or commodities as these are risky instruments. A volatile market may force you to sell securities at a significant loss especially in case of a short time horizon.
A longer time horizon gives you more time to recoup losses, that is, averages out different market levels and is therefore, tolerant of higher risks. For example, if the Rs 5 lakh was meant for your child’s higher education after 10 years, you can opt for high-risk instruments as you have a longer time in hand.
Risk tolerance: Knowing how much you can afford to lose also helps in figuring out your risk-taking ability. You can invest in high risk instruments only if you are prepared to lose the capital. Here, you won’t be pressured to redeem the investments because of economic or liquidity issues.
Larger the amount in hand, bigger will be the risk you take and vice versa. For example, M has a portfolio worth Rs 5 lakh and P has a networth of Rs 50 lakh. If both invest Rs 1 lakh in securities, the person with the lower networth will be more affected by a decline in value than the person with the higher networth. Furthermore, if the investors need cash immediately, the first investor may have to sell off this investment, while the second one can redeem from other funds.
Investment risk pyramid
After determining your risk appetite, you can use the risk pyramid method to balance your assets. This pyramid can be used for asset allocation to portfolio diversification according to the risk profile of each security. The pyramid, representing the investor’s portfolio, has been shown in three distinct tiers (See Pyramid) :
Base Layer: This comprises of investments that are low in risk and have foreseeable returns. It should be the largest area and the bulk of your assets.
Middle Layer: This part comprises of medium-risk investments that offer stable returns while allowing capital appreciation. But these will more risky than the assets in the base layer.
Top layer: This is for high-risk investments, this is the smallest part and should consist of money you can lose without repercussions. This money should be fairly disposable so that you don’t have to sell it prematurely in case of a capital loss.
Your risk appetite is also determined by your age, financial goals, value of investment portfolio and so on. While an elderly individual near retirement may prefer less risk, a young person with little or no responsibility may be comfortable with high risk.
Indicative returns: An informed investor not only researches on instruments but also understands his finances and risk profile. To get an estimate of the securities suitable for certain levels of risk tolerance and to maximise returns, investors should have an idea of how much time and money they have to invest and the returns they are looking for.
Indicative return for some of the investment categories:
Tax efficiency: While determining the expected returns, one should also look at the tax efficiency. Income from bank deposits, Post Office instruments, non-convertible debentures (NCDs), bonds are taxable and their post-tax returns are lesser based on your tax slab.
For instance, dividend from equities is exempt from tax and so is long term capital gains, however, short term capital gains is taxed as per slab.
In real estate, if holding period is more than 3 years and there is any gain from the sale of property, then the gain is called long term capital gains for which you get indexation benefit. If held for less than 3 years, it is treated as short term capital gains and taxed as normal income. The tax incidence determines whether the returns that you expect are attractive or not.
Balancing a portfolio lies in adhering to the principle of portfolio diversification. Remember, stocks help your portfolio grow, bonds bring regular income, cash provides emergency reserve and stability and real estate, gold provide help hedge against inflation. Better the asset allocation (based on your risk profile), higher will be the returns.
The writer is a freelancer