Instead, financial goals should decide risk appetite
Investment is a process of allocating money to assets for creating wealth and achieving financial security. There are several investment options. Each comes with ample risk. Selection is largely based on the investor's risk appetite. Also, traditional belief is that age determines an investor's risk-taking capability. Is that true? Should we manage our portfolio based on age?
Risk Vs Age
Investing in equities can fetch great returns. However, the risk involved is high. According to the traditional school of thought, a person should reduce exposure to portfolio risk as he grows older. Here, risk primarily refers to equity risk. According to a thumb rule, the proportion of equity in your portfolio must be equivalent to 100 minus your age. For example, if you are 30 years old, your portfolio can have 70 per cent equity. This means as you grow older, you must move your portfolio from equity to debt. But it is time to change this thought.
The risk a person takes must be based on his financial goals, irrespective of age. Along with his goals, he must also consider the time period to achieve those goals, his financial situation as well the returns expected. These four things determine his risk appetite.
A 60-year-old person who wants to start a business after 10 years cannot depend on debt funds. Instead, equities will yield higher returns. Again, if a person's goal is to earn stable and steady returns each month, he must invest in debt funds.
Financial goals can be short-term or long-term. It is important to segregate them and choose investment options accordingly. You cannot invest in the same instrument for two widely different purposes such as your child's education, which is likely to be after 12 years, as well as for purchasing a car in the next one year. Equities, real estate, gold and government schemes are ideal for long-term goals. Debt funds are ideal for short-term goals.
The returns expected are as important as the time required to get those returns. Some investment options might give higher returns than others. If you are looking forward to a massive amount, investing in a bank fixed deposit (FD) will not serve your purpose. Equity and real estate must be looked at in such a scenario. At the same time, if your goal is to raise an amount in the next five months, a bank FD is the perfect option. Investment options can have different features: safety, stability, risk, returns, etc. So, while choosing your investments, consider all these to make sure that they are in line with your goals.
The investor's financial situation also plays an important role in risk management. A person who earns Rs 5 lakh per annum and another who earns Rs 12 lakh per annum will have entirely different sets of options. Other things like marital status, gender, family responsibilities will also be the deciding factors.
Let's see a few examples of allocating assets based on differences in age and financial situation. Generally, an individual is expected to start earning when he is around 21-23, after completion of studies. He might start his career with a monthly salary of Rs 20,000. In such a scenario, he can open a recurring deposit. Once he has accumulated a considerable funds, he can open an FD account. SIP is also a great option to begin with, as the minimum amount is only Rs 500.
Now, if a person begins his career with a salary of Rs 30,000 or Rs 60,000, he has vast options. He can invest actively in mutual funds, government securities or even gold. Public provident fund (PPF) is a common choice across age groups due to tax benefits.
After some years of employment, appraisals and better opportunities are expected to increase a person's salary. This means equities can be an option. Equity investments could be either direct or via mutual funds. Real estate is also a great option to create wealth over time. Bank FDs and liquid funds could be maintained for emergencies. Now, as we have understood how to manage risk based on age, it is important to have clarity on the five major investment options available:
Debt instruments: Fixed interest generating securities are called debt instruments. There are a number of debt options such as commercial paper, corporate bonds, government securities, treasury bills, bank FDs, etc. Debt instruments provide steady returns and are just right for those with a low risk profile.
Equities: Equities are nothing but shares of companies. You can invest either directly or through equity mutual funds. Equity instruments aim to give higher returns but are subject to market risk. Returns and risk involved are largely influenced by market dynamics.
Real estate: It involves investing in land or property. You can buy land or property for a price and later sell it for a higher price. Real estate investment can be really rewarding. The major advantage is capital appreciation.
Gold: Indians have been investing in gold since ages. Gold prices have been increasing rapidly, and the yellow metal is likely to yield good returns over a long period. Some common options for investing in gold are: gold exchange traded funds, sovereign bonds, digital gold. However, the proportion of gold in your portfolio should be 5-10 per cent and not more.
Government securities: Besides, there are a number of schemes offered by the government such as PPF, National Pension Scheme, National Savings Certificate, Atal Pension Yojana and many more. There are for every section of the society and age group. These give fixed returns over long periods. They involve very low risk as they are backed by the government.
So, basically it is financial goals that decide the risk appetite and not age. We all have heard that "age is just a number"; it is high time we incorporate this thought in our financial decisions as well.
The writer is Founder and CEO of indiamoney.com