Understanding our risk profile is an important step in the process of planning our investments and finances. It is based on our risk profile that our investment strategy is determined and our portfolios are constructed. The most common assumption among investors everywhere is that those with an aggressive risk profile must only opt for aggressive investment strategies and those with conservative risk profiles should only opt for low risk strategies. But in reality, a moderate risk strategy is the most viable strategy for investors to follow regardless of their individual risk profiles. Therefore, in today’s blog post I am going to delve deeper into the importance of following a moderate risk strategy when constructing our investment portfolios and show how it can bring about a significant improvement in our investment performance.
To fully understand the importance of following a moderate risk strategy, we must first realise the rationale behind recommending it. An individual's risk profile is a mix of their risk capacity (ability to take on risk) and risk tolerance (willingness to take on risk). And most individuals today are well educated, have secure jobs, are able to secure a stable periodic income from their jobs and are able to put away a part of their income regularly to serve as savings. But at the same time, they may have a number of people who are financially dependent on them, outstanding debts and lifestyles majorly characterised by an undue focus on consumption. This means that their risk capacity is neither too high nor too low. Also, most individuals today are much more aware about the importance of investing and managing their finances. They are also relatively better informed regarding the risks involved with various investment products. But even so, they may not be explicitly willing to take on risks because of their value systems, life experiences and perceptions of investment risk. This means that most individuals have a risk tolerance level that is somewhere in the middle of the spectrum too. All of this means that most individuals have a moderate risk profile. And this is true for individuals in India and everywhere in the world. Therefore, given that it is extremely rare to see an individual with a risk profile that is purely aggressive or conservative, a moderate risk strategy would be the best one to follow more often than not.
Having understood the rationale behind adopting a moderate risk strategy, it is time to delve into the exercise of building an investment portfolio tied to a moderate risk strategy. As with any other investment portfolio, asset allocation is at the heart of this exercise. Adopting a moderate risk strategy does not mean that we need to construct portfolios with the majority of our money being allocated to a single low risk asset class. It is perfectly possible to construct a moderate risk portfolio following a multi asset class approach. In fact, achieving long term financial goals requires us to allocate at least 50% of our portfolios to riskier asset classes such as equity. Therefore, the best way to build a multi asset class portfolio that is tied to a moderate risk strategy is to rationalise risk through product choices within each asset class.
Those who wish to follow a moderate risk strategy may construct the equity portion of their portfolios by limiting their exposure to established large cap stocks. The dividends from these stocks would serve as a reasonable source of additional cashflow for investors. An even simpler choice would be to stick to reasonably liquid large cap index funds. The debt portion of such portfolios may be constructed using more traditional products like EPF, PPF, NPS and so on. The tax benefits that come with these products would be an added advantage for investors. Some exposure to debt mutual funds may also be considered. Those who wish to gain exposure to gold within their portfolios may consider allocating not more than 10% of their overall portfolios to gold ETFs and gold mutual funds. Weightages of each asset class within the portfolio may be decided based on our goals, circumstances and financial realities.
Adopting a moderate risk strategy allows us to operate with enough headroom at both ends of the spectrum of investment risk. This allows us to take advantage of every opportunity presented to us by the markets. When the economic context and the market context are in our favour, a moderate risk strategy gives us enough confidence to top up our investments at moderated valuations. This automatically boosts our investment returns in the future. On the other hand when the markets and economic context are not in our favour, we would automatically become cautious and protect gains generated in the past by booking out of our investments and reverting to holding cash. All of this means that our responses to any situation thrown at us by the markets and life as a whole would be swift and timely, yet measured and contextual. It also means that our investments would be insulated against most financial shocks. And in the inevitable eventuality that our investments are affected by a financial shock, a moderate risk strategy ensures that the impact of such shocks would minimal and manageable. Therefore, following a moderate risk strategy allows us to enjoy a greater degree of comfort with our investments. And that effectively means that we would be at peace with how our money is being employed.
But what about the kind of returns that a portfolio built to a moderate risk strategy can generate? Though the returns achieved by following a moderate risk strategy are never exciting, they are still significant and sustainable enough to help us achieve all our financial goals and get the most out of our money. Orienting portfolios towards achieving moderate returns that sustain over decades is better than orienting them towards achieving supernormal returns which last for only short bursts of time. Of course, generating supernormal returns of say 20% plus is great. But such returns should never be achieved at the cost of not being cognisant of the risks we have taken on to achieve such returns. And given that supernormal returns are not sustainable, the risks involved would ultimately prove to be fatal to our portfolios. Far too many of us overestimate our capabilities as investors and assume that we are immune to such situations. But we often forget that we are ultimately human. And given that the best investors in the world also get caught out by adverse situations, ordinary investors like us cannot hope to do any better. Therefore a moderate portfolio return of say 12-13% compounded over a long period of time is a lot more achieveable, comfortable, sustainable and rewarding.
By now it should be clear that following a moderate risk strategy when constructing and aligning our investment portfolios is not as mundane and unattractive as it sounds. It gives us a clear set of principles based on which to manage our investments. It ensures that each investment product within our portfolios plays a clear role in helping us achieve our financial goals, while always ensuring that inherent portfolio risk is never too high. It gives us the confidence and conviction to take the right investment decisions at the most opportune of times. It gives us a well rounded idea of where we are going with our money. It ensures that we always have clarity with regard to the way we need to handle a particular situation that faces us. It ensures that we are at complete peace with our investments at all times. A moderate risk strategy is therefore one that is not only aimed at managing investment risk, but also at optimising investment performance and maximising our chances of success. All of this effectively means that each of us would be able to enjoy better investment returns at reasonable levels of risk in a sustainable manner by adopting a moderate risk investment strategy. It would therefore benefit each one of us to adopt a moderate risk strategy when building our investment portfolios.
Comments