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Beginners' guide to wealth creation Part II: Formulating an investment strategy

Mudit Kapoor     June 11, 2018

Beginners' guide to wealth creation Part II: Formulating an investment strategy

This is the second part of a three-part series on investments and wealth creation for beginners.

As explained in the previous article of this series, investing can help you build wealth in the long term. In this article we will try and learn how to formulate an investment plan.

An investor should adhere to the following steps, while investing, as a ground rule.

6 steps to be followed while investing:

1. Set your financial goals

2. Know your risk profile

3. Create an investment plan

4. Choose asset mix

5. Choose investments

6. Timely review of the investment plan

First and foremost, an investor should take stock of their current earnings and separate a comfortable amount from their savings that they can invest towards wealth creation.

1. Set your financial goals: A financial goal refers to the accumulation of money over time which helps to fulfill a particular objective. The duration of such financial goals can be short term, medium term or long term depending upon the capital required to fulfill such goals. For example buying a mid-segment car could be a short term goal (<1 year) while buying a house will be a long term goal (10-15 years).

2. Know your risk profile: This is a very important step in the investment plan formulation as the return is dependent on the risk undertaken. Bigger the risk, greater the returns! So, let's understand the concept of risk in detail.

What is Risk: When an investor thinks about investing, the first thought that comes to their mind is of risk (uncertainty). Common investor fears the risk of losing their investment in whole or a part of it, or making less than expected returns on their investment.

What is Risk Profiling: An investor makes investments in order to achieve certain financial goals. Risk profiling is the process through which an appropriate investment strategy can be formulated for the investor taking into consideration the risk factor.

Risk profiling involves assessment of these 3 factors:

A. Risk capacity: There is always a level of financial risk that an investor can afford comfortably based on his/her life situation. Beyond this level of risk, the investor may show signs of restlessness (e.g. risk capacity will be higher for a young salaried investor as compared to an older aged investor with two kids).

B. Risk tolerance: This refers to an investor's ability to cope at a psychological level with the volatility of capital markets. This is the level of risk that the investor prefers to take (e.g. response/reaction towards market movement.)

C. Risk requirement: This is the risk that is associated with the level of return that the investor is seeking to achieve to fulfill their financial goals within the constraint of limited financial resources.

How is risk profiling done?

There are multiple risk profiling tools available online which you can use to get your risk assessment done. Upon completion you will be put into one of the risk buckets depending on your responses to the questions (Risk Averse, Risk Neutral and Risk lover). Once you know your risk profile you can ascertain what kind of investor you are, what kind of returns you should expect from your investment portfolio and what kind of investment portfolio you should have. Investors who want no risk to principal should not invest using stocks. Stocks may have attractive long-term potential, but investors must be willing to bear fluctuations in the market. Certificates of deposit (CDs) offer comparatively lower returns, but the principal amount is guaranteed. Each investment has an appropriate level of risk that can be measured using financial statistics. Standard deviation, beta and alpha can be helpful for investors looking to measure risk and volatility of a particular investment or portfolio.

Benefits of risk profiling for a novice investor:

A good financial plan aligns your goals with the capacity to take investment risks and risk tolerance. As a beginner, knowing your risk profile can benefit you in multiple ways:

"Take calculated risk - calculated risk, based on investor's risk capacity and return expectations, would provide peace of mind according.

"Tapping suitable investment opportunities - get to know the right asset mix depending on your risk profile (e.g. appropriate balance of equities, bonds, derivatives, different kinds of mutual funds, etc).

"Readiness to acknowledge uncertainty of returns - investor would be aware of how to react to market ups and downs, and how best to keep emotions from getting in the way of long term wealth creation.

Risk profiling is advantageous for all investors, but beginners stand to gain the most, as it helps set the right investor expectation and gives an excellent opportunity for advisors to get a glimpse of their client's aspirations, attitude and tolerance.

3. Create investment plan: After ascertaining your risk profile, you need to create an investment plan through which the investible amount can be used to buy investment products on a regular basis, while maintaining the principle of diversification to minimise the risk incurred. For example, a younger investor below 30 can opt for a much aggressive portfolio as compared to a middle aged man who would prefer to have safety of principal amount with more investments in fixed income instruments such as fixed deposit of debt mutual funds.

4. Choose asset mix: Asset mix refers to the breakdown of the portfolio of securities into its constituents. The asset mix should be in line with the risk appetite of the investor determined during the step 2 (Know your risk profile). Asset mix should aim towards maximising the returns with the given risk taking capacity of the investor. For example a young salaried employee under the age of 30 years should aggressively invest into stocks (>30% investable income) and equity mutual funds (>50% investible income) and the remaining into liquid investments such as Fixed deposit and bank savings.

5. Choose investments: After determining the asset mix of your portfolio, the individual asset classes should be further broken into the investment avenues. Continuing the above example, now our young investor should pick the stocks for 30 % of investment into equities. For him 50 % of the investment in mutual fund would be appropriate but there are more than 2599 mutual funds schemes available in India. The investor should look at the past performance of such instruments and their beta factor which represents the stock's volatility with respect to the market changes. At the end of this step, the investor should divide his investible income into individual stocks and mutual funds that would constitute his portfolio

6. Timely review of the investment plan: Investor should review the returns obtained from each of the constituent asset class from time to time. Generally, a year's time should be given before first alteration of the investment plan. If any of the constituents are not performing up to the return expectation then that asset should be replaced after careful review. Such alterations should not be made very frequently as for some assets there may be entry or exit load which may decrease the value of portfolio.

Happy investing!

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