Most often than not in our wealth management journey, a lot of emphases is placed on products and returns one can expect from them.
In fact, when setting a wealth objective, the focus is also on setting a numerical return objective whereas risk is subjectively considered as high, medium and low.
However, return and risk go hand in hand and in fact while the return is an outcome, the risk is actually a variable that can be managed. Moreover, risk can be measured in numbers just like returns.
The correct approach for an investor would be to first define the desired return and risk objective in numbers followed by creating a strategy which involves identifying the right asset mix and product mix within that asset class that best meets your return and risk objective.
Risk-taking ability can depend on age, investment horizon, liquidity requirement and return target for investments so let us understand what are the critical risks that one should be aware of, how you measure them and most importantly how you manage it.
While devising a return objective one should be aware of Inflation Risk. Inflation is the increase in the price of goods and services we consume.
The impact of inflation may not be visible in a year or two but as the time period increases its impact increases.
The government measures inflation through CPI (consumer price index inflation) which is currently at 7.3%. To mitigate inflation risk, when setting a return objective, one should look at generating a return of upwards of 10%.
Market Volatility risk
This is the risk of fluctuation in portfolio return. This occurs mainly due to fluctuations in the prices of stocks/equity instruments in one’s portfolio.
This can be measured by the standard deviation to compute the absolute volatility of portfolio return and by Beta to compute volatility risk in relation to a certain benchmark.
The best way to manage volatility in returns is by having (i) the right asset allocation in the portfolio and (ii) a less correlated product mix in the portfolio.
How to construct a portfolio?
You should look at creating a portfolio which beats inflation while managing volatility.
We Save money and invest so that we can spend the same in the future, therefore Investment can be called deferred expenditure.
Naturally, the objective of investment has to be to retain purchasing power by beating inflation.
Volatility on the other hand is nothing but the turbulence that your portfolio will experience in the process of attempting to achieve the targeted return.
So, naturally one would like to see lower volatility. But we all know lower the risk lowers the return potential. For e.g. FDs will be the least volatile because FDs will deliver what was targeted at the beginning by the end of it. But the same is not true with an equity mutual fund.
Currently, the inflation which is CPI is around 7.3% so therefore if one set a return objective to beat the current inflation post-tax then the return target should be about 10% or more.
It is important to define and understand your downside risk-taking abilities like the upside risk.
Say, one takes a return target of 12% and a volatility target measured in the standard deviation of 6% for three years in such a scenario, this would mean that you are expecting the performance to range somewhere between 6-18% which is nothing but 12% minus 6% and plus 6% which is the range in which the return will mostly occur.
There are broadly four contemporary asset classes to choose from and the risk and return trade-off of each of these four is different.
Allocating your resources across these asset classes is called asset allocation.
• Growth-oriented – equity and real estate
• Defensive-oriented – debt and gold
Based on research by Brinson, Singer and Bee bower - Asset Allocation determines about 93% of the return variation between portfolios followed by security selection and market timing.
Every product should have a historical track record of return and risk potential.
Selecting the product that has the best possible risk-return equation while helping us achieve our objective is important. E.g. If MF and PMS have similar return potential say 12-15% and MF has an SD of 12% and PMS has an SD of 16% then one should opt for a product with a lower risk.
Thus, protecting your portfolio while managing risk is the key to building a successful portfolio.
If you follow the above steps then there is only one thing to keep in mind while creating a portfolio let the math and data dictate your portfolio construction, not emotion or sentiments.
(The author of this article is Director & Head - Product & Research, Anand Rathi Wealth)
Disclaimer: The views and recommendations given in this article are those of the author. These do not represent the views of MintGenie.