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Balancing the risks

More families today are exposed to different risks when creating wealth. How to manage them?

By Clifford Alvares        Print Edition: July 29, 2007

 
Covering his family against risk: A senior executive at Shriram Pistons, Sharma has planned well for risks.
R.B. Sharma, 54, covered his life with policies amounting to Rs 1.5 crore. He believes in assured returns and has invested in debt mutual funds and fixed deposits. Only about 10-15 per cent of his portfolio is in stocks, which reduces his risk considerably.
When financial planner Amar Pandit asks his investors: How much percentage loss can you take? Answer: Around 5 per cent. "Investors don't want to take a big percentage loss," says Pandit. "A 10-per cent loss can appear unbearable." But when asked: Can you afford to lose Rs 10,000 on an investment of Rs 1 lakh, the answer is more often a surprising yes. That contradiction seems to stem from an ability of investors to gauge and take calculated risks. "If they know the amount they are going to lose, investors usually don't seem to mind," says Pandit.

But financial risks can hardly be quantified and calculated easily. A stock portfolio corpus could easily get pummelled because of market volatility. Long-term bond funds can turn quite risky if interest rates are headed up. Defaults of lower-rated corporate paper can easily wipe out a big chunk of any corpus. Cash appears safe, but it's vulnerable to the risk of inflation, or the risk that the money will not have the same worth in the future.

Interest rate hikes could see housing assets depreciate, and increase your monthly installments. Then there's opportunity risk-of parking money in an asset that provides low returns such as a savings bank and lose the opportunity of a high growth investment. Risks are plenty. And more families are increasingly exposed to all kinds of risks. So every financial decision should be taken with an eye on the risks involved. Says Pandit: "There are various factors that you can't control such as oil prices, geopolitical factors, but some critical personal money decisions can help curtail risks. People have to educate themselves about risks."

Assess and beat

Investors can't take calculated risks in the stock markets, except for arbitrageurs. In the short term, the markets are increasingly vulnerable as they move quickly and unpredictably in whichever direction. It's here that investors often end up making the classic trap of jumping in when the markets go up and running scared when it tumbles. Two critical steps can substantially reduce stock investing risks. First, take a long-term view-preferably 10 years or more. Here's a fact: a longer time horizon reduces the risk of volatility and improves returns. The Sensex returned a sound 18.8 per cent compounded over the last 20 years (Rs 1 lakh invested 20 years ago is worth a solid Rs 31,62,464).

 
SIP is the way to go: And for Srinivasan, it’s the best bet as of now.
P. Srinivasan, 29, uses the SIP route to invest in mutual funds. This ensures that he averages his investments both on the downside and on the upside. He has enough backing to ensure that he does not have to make any distress sale of his assets.
For Haresh Sadani, stocks are for the long-term. This 32-year-old Assistant Vice President at an asset management company has invested in mutual funds. "Stocks are risky, but I am not worried over the long-term. I don't monitor my funds regularly," he says. Direct investing is risky so he allocates only a small percentage of his corpus here.

Second, diversification helps spread risk among stocks. A portfolio comprising just one or two stocks or just one sector is vulnerable to swings in that sector. Add to that a discipline of buying stocks when markets are down and you can increase your returns manifold. Adding different asset classes protects your portfolio substantially. Himangshu Bhattacharya, 62, has diversified into mutual funds, bank fixed deposits, and post-office savings, and some in his software business. "If you put all your money in one place, you always run the highest risk. I have all along believed in spreading it out," he says.

 

Another way investors can profit is from systematic investment plans of mutual funds. Palaniappan Srinivasan has found this method an easy way to average on the upside and downside. Though this 29-year-old it professional is not a big-time investor in stocks, he looks for a three-year track record of performance and for attractive prospects. "At my age, I would like to invest in developing company stocks-which could have greater risks, but can provide greater returns. When I touch 40, I will turn conservative in stock selection."

 

Five questions to assess your risk profile

 
If you won a lottery, where would you invest most of it?

1. Government savings and bonds
2. Mutual funds
3. Equities

What kind of investor would you call yourself?

1. Conservative
2. Cautious, but open to opportunities
3. Aggressive and willing to take risks

Do you constantly think about your investments?

1. Check investments occasionally
2. Do a regular check
3. Continuously monitor my investments

What would you choose if you are offered the following options?

1. Rs 10,000 in cash
2. A 50-per cent chance of winning Rs 50,000
3. A 25-per cent chance of winning Rs 1,00,000

What is your most important investment goal?

1. To conserve your original investment
2. To beat inflation moderately
3. Make the highest returns

If your answers largely comprise of the first choice, your risk profile is conservative. A consistently third choice makes you an aggressive investor.

Real estate investors face a concentration risk. Too much of one type of asset is detrimental if the demand for this asset weakens. Real estate also faces the risk of liquidity-you can't sell it off immediately. On the other hand, this asset provides the benefits of financial leverage if asset prices increase and you have financed the property through a bank loan. Says Pandit: "This asset has the potential of leverage, but the risks of concentration and illiquidity are a major hindrance." For investors who prefer real estate, it's best to look for property in locations that are growing and where demand potential is high.

 
MFs all the way: Sadani’s choice.
A home loan cover has 32-year-old Haresh Sadani's family protected. He keeps aside about 15 per cent of his funds for direct equity investments, which he feels is risky. But since his investments are of a longer tenure, the risks are reduced. Investments in mutual funds, too, are for the long haul, which Sadani evaluates occasionally. 
Fixed deposits and bonds are among the least risky, but in the risk-reward spectrum, the returns from these assets barely keep ahead of inflation. Government securities are safer as they carry a sovereign guarantee. Investors are also affected by the interest rate risk, which has a huge impact on bonds. When rates rise, bond prices fall. The longer the bond's maturity period, the more its price will fall. For example, a 30-year bond will fall harder than one that matures in five. So invest in bond funds that have a maturity period of around one-to-two years as the impact of interest rates on them is lower. There's a possibility that bond fund assets could default. All bond fund holders face this risk.

Cash may appear safe, but it's affected by inflation. The same amount of cash will not be able to buy the same value of goods one year from now. Inflation eats into the purchasing power of money, and is the biggest risk investors face today. Says Pandit: "It's a hidden risk and therefore you have to have assets that beat inflation by a comfortable margin."

Take Cover

Even today there are many people who have not got sufficient life insurance to protect their families. A cover on life helps in more ways than one. "There are two risks that get covered through life insurance-the risk of dying too early and the risk of living too long," says Vinay Taluja, Vice President, Bajaj Capital, a wealth management company. Both the risks are taken care of by life insurance covers. Fifty-four-year-old R.B. Sharma has cover for a total value of Rs 1.5 crore. "I always believed that one must cover one's family against risk," says the Senior General Manager from Shriram Pistons and Rings.

 

Six ways to mitigate risks 

Get Life Cover
It's the one risk that is insurable. Premiums on a term plan aren't too expensive, but it ensures that your family is well taken care of in case of any eventuality

Don't Chase Returns
Aggressive investing is often the cause of many a loss. Riskier assets give the highest returns, but there's an unlimited downside to them

Diversify
A healthy mix of different assets, mutual funds, fixed deposits and stocks is the only way you can ensure maximum safety of your assets. Not all asset classes fall at the same time. It can reduce overall returns, but protects against maximum losses

Don't Over Leverage
It may help you multiply your returns, but at the same time over leveraging can get disastrous if the market tanks. It can multiply your losses

Think Long Term
The longer your investment horizon, the lower is your risk from stocks. But ensure that you have a carefully selected portfolio that is regularly monitored

Hedge for Inflation
It can cut into assets in a big way if you don't have a healthy mix of inflation beating assets. Make sure you have some stocks and equity mutual funds in your portfolio

If the objective is pure insurance and not returns, then term policies are for you. A term insurance makes sense as the premiums are cheap and the objective of covering your life is achieved. There are various benchmarks as to how much cover one should take. But a general thumb-rule would be to take a policy that covers at least 10 times one's current annual income.

All investments involve a certain amount of risk, and the general rule is that the more the returns, the more the risks. But if you don't take risks at all, then inflation will hit you. Investors have to find out their own ideal balance of risk and reward. Just equally important, there can be no rewards, without risks.

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