Investing 101 Part 4: How should you invest - Risk Profile and Goals

So far in the previous parts we have seen why one should invest, the various investment asset classes available (equity, debt, real estate and gold) and what to expect from each, what Mutual Funds are how they can help individual investors to invest in different asset classes.

But how much should you invest and how should you distribute it across asset classes - especially between equity and debt? Equities (stocks) give the highest returns in the long run, so should one invest everything in equity?

The answer is most probably no.

Risk Profile

Equities go up and down a lot on an annual basis. In extreme cases like in 2008, the stock markets went down by more than 50%. If you had invested everything in equity, your investments would have also gone down by 50% or more. Could you (or your investment advisor) have side-stepped it - getting out without as much loss and then getting back in as soon as it was over? Unlikely. If it was possible to predict such crashes, then they would never happen.

Very few people, if any, can stomach such losses and not panic. Surely, the markets recovered in the coming years, but in 2008 while staring at a 50% loss, it would have been difficult to say when the crash is over.

We don't want to be in such a situation. However, this does not mean that we can't stomach any temporary losses. Ask yourself - how much loss would you have been okay with during an economic crisis like that of 2008? This simple question can help you figure out your risk tolerance.

Most people say they would have been okay with a loss of 25-30% in their portfolio. Now we know that the equity part of our portfolio would have gone down by 50% or more during 2008 no matter what. So the simplest way to ensure that your total portfolio is down only 25-30% even in such extreme situations is to allocate only half of your money to equity and the other half to debt (which gives you FD-like returns not linked to the stock market).

Say your total portfolio is Rs 100. You invest Rs 50 in debt and Rs 50 in equity - both easily doable through Mutual Funds. Now, come a crash like 2008, the equity portfolio goes down by 50% and becomes Rs 25. The debt portfolio does not go down and in fact increases by the prevailing FD rates at that time, say 10%. So the debt part increases from Rs 50 to Rs 55.
Your total portfolio value is now Rs 25 + Rs 55 = Rs 80 - a loss of only 20%.

Another good rule of thumb to identify your risk profile is to see if your investments in the equity market are making you nervous or lose sleep. If yes, then you are probably over-invested in equity and should move some of your money to debt. 'Sell it to the sleeping point' goes the advice. It is important to not ignore the emotional aspects of investing lest we end up taking too much risk and then bailing out at the worst moment.

So the first step is to always invest according to your risk profile.

What are you investing for - Goals

The second important piece of the investing puzzle is to know what are you investing for. Are you investing for a down payment of a house to be purchased in the next 2-3 years or are you investing for your retirement which is 30 years away?

The two goals have very different time horizons and hence need to be managed differently. The asset allocation for a house down-payment 3 years down the line will be primarily in debt because equities are too unpredictable for this short a time period. Similarly, for your retirement, the asset allocation should be heavily tilted towards equities because the time horizon is long enough to reap the high returns from equities.

One can have multiple financial goals of varying time horizons at the same time - for example a newly married couple might be saving for a house to be purchased in the next 3 years, for their child's education in the next 15 years and for their own retirement in the next 30 years.

Also note that the asset allocation can not be static through out the duration of a goal. A 10 year goal might start off with a high percentage of equity allocation but after 6 years, it is now only a 4 year goal and its allocation should be according to a 4 year goal - more debt and less equity.

Putting it all together

Coming up with a financial plan for yourself involves figuring these two things out - your risk profile and your goals. Then for each of your goals, depending on their time horizons and your risk profile you can calculate an year-by-year allocation to equity and debt.

Once you have done that, the equity part can be invested in the best equity funds and the debt part can be invested in the best debt funds of that time.

Apart from the annual review of asset allocation for each goal, the fund selection also needs to be reviewed each year so that you don't get stuck with a poor-performing fund.

If all this sounds tedious, that's because it is. And this is where Goalwise comes in.

You can create as many goals as you like on Goalwise and it's in-built algorithms will compute the appropriate asset allocation for each of your goals by taking your goal's purpose, time horizon and your risk-profile into account - not just for the starting year but for every year till the goal's duration is complete.

Goalwise also automates selection of best funds for both equity and debt and automatically reviews your portfolio annually and switches from old to new funds as and when required in each of your goals. You can read more about Goalwise's fund selection strategy and how it beats the Sensex here.

In this way, Goalwise automates all the best practices of goal-based investing for its users thus providing a completely managed end-to-end set-and-forget system.

Give it a spin here and let us know what you think. :)