Weigh in Your Investment Objective for a Sturdier Portfolio
When investing into investment products, we must accept that risk can be mitigated and not eliminated.
When the going is good, no one bothers to think about aspects like asset allocation, diversification and buying protection. It is only at turbulent times like these that reality strikes and investors come forward to discuss their concerns and what changes, if any, do they need to make in their portfolios so as to reduce the risk of further erosion of capital.
It is important to understand and appreciate that when any investment is made into a product other than a deposit, some element of risk is assumed by the investor. The risk varies depending upon the nature of the investment. Hence, when investing into investment products, we must accept that risk can be mitigated and not eliminated.
Let us try and address some of these aspects and help investors manage their portfolios.
Over generations, the only way to reduce risk in your portfolio is through asset allocation. Asset allocation refers to allocating your assets basis your risk appetite, expectation of returns and holding period of the underlying investments. An investor wanting money in three months is best placed to invest the sum in a short term deposit or a money market fund; an investor who has invested his or her capital into a new business is better served to use any liquidity towards creating a fixed income portfolio. Older investors who may not have any other source of income are best advised to allocate a disproportionate amount of their portfolio towards fixed income investment(s). While every investor expects high return with low risk - in real life that maxim does not work. Hence, asset allocation serves as a good starting point when an investor is building his or her portfolio.
Diversification is an important tool to reduce risk since all asset classes are unlikely to move in the same direction all of the time
Diversification is an important tool to reduce risk since all asset classes are unlikely to move in the same direction all of the time. Investors should diversify across different types of fixed income instruments depending upon the underlying risk; equity allocations should be undertaken looking at the size of companies and their respective market capitalisation(s), attempt should be made to look at diversifying across asset classes such as commercial real estate and gold and international diversification is increasingly a recommended option given that it a hedge against rupee depreciation and also provides investors access to global markets that are ordinarily not available to investors based in India.
Thirdly, just like we buy life insurance to protect the family against unforeseen events, investor can buy protection to protect against unanticipated volatility in their equity portfolios. This protection can either be executed through a purchase of a vanilla put option that expires worthless in case the market trades at a higher level than the level at which protection was sought or through a zero cost option where the investor buys a put and funds the purchase of the put through selling a call (giving up upside). Typically, protection should be bought when the volatility is low such that the premium paid is low.
Understanding Product Dynamics:
While investment products in India are less complicated than what products exist outside of India, investors need to understand the product that they are buying and the risk that they are assuming prior to purchasing the product. Buying AT1 bonds and treating them like deposits, thinking that fixed income means no credit or liquidity risk or buying equity stake in small cap companies that are illiquid just basis past performance are highly avoidable. Caveat Emptor is a good practice for all investors to follow.
Last but not the least, just like with asset allocation, creating a systematic investment plan for purchasing equities is a time tested phenomenon that has worked well for investors. No one can time the market bottom or the top and it is best that a plan that allows an investor to invest monthly or quarterly is created and is an appropriate way for investors to plan their equity investments.