How to Invest: Your Investment Profile
Now that you have an understanding of the how to invest: basic investing principles, its time to determine your investment style, or investmentment profile. The investment profile plays a crucial role in devising an investment strategy that can help you meet your investment goals without exceeding your tolerance for risk.
Your investing decisions are heavily influenced by your financial circumstances and your personality. No two individuals are alike in terms of their financial situation, their requirements from an investing plan, or in their ability to handle or tolerate risks. Infact each individual needs to tailor the investment strategy, or how to invest, based on his/her investment profile. Thus crafting your own investment strategy would require an understanding of how various aspects of your investment profile affect your investment decisions.
Your Investment Profile
We have seen in the first article in this series - how to invest: basic investing principles - how investment decisions are based on the risk/return trade-offs and the ways you can mitigate the risks. You will now see how your investment profile affects the risk/return trade-offs you may be willing to make and thus your ability to reduce the risks. Your investment profile decides how to invest, depending on your financial circumstances and personality traits, as below:
- your return requirements; whether you need current income or future growth
- your tolerance for risk
- your time horizon, that you can stay invested
- your tax exposure
Let's examine these aspects individually and their impact on investment decisions, now in more detail.
Return Requirements
Our return requirements are often dictated by our financial situation.
Some will be looking at how to invest strategies to save for a future event such as buying a house, a child's higher education or marriage. These circumstances would require that the investments are aimed at generating higher returns for healthy growth. Since the investment is meant for meeting a future financial goal, you will be willing to stay invested for a longer term.
There will be some who want how to invest strategies that make annualised (or even monthly) returns every year to augment their current income. These circumstances dictate that the investments generate consistent annual payouts and that the capital is protected. You will probably be looking to remain invested for the medium to long term in such investments.
There will also be some who want some current income as well as future growth. Let's see how the how to invest - common investment options stack up on these risk/return trade-offs.
The how to invest risk/return trade-offs become apparent here isnt it. If principal protection is important, you will have to settle for lower return instruments such as bank FDs or Bonds. This is because the more certain the annual payments, the less risky the investment, and therefore lower the potential return in the form of growth.
On the other hand if you are looking for growth strategies, you will need to settle for less certain principal protection and thus take on more risks by investing in high-quality Stocks or reputed Mutual Funds.
Looking at the above table and the examples of how to invest options with return characteristics may help you identify your return requirements. One may invest in other investment options (Equity Diversified Mutual Funds, Balanced Mutual Funds, or Gold for instance) with their attendant return characteristics. It is certainly possible to meet your return requirments by diversifying across different how to invest options in proper proportion, as long as you have identified them properly along the lines, as exemplified above.
Risk Tolerance
Now we have come to a crucial aspect of your investment profile - your tolerance for risk. How much risk are you willing and able to take on is extremely important for defining your how to invest profile. We all know the consequences of taking on too much risk.
We have seen/read about how many investors panicked during the recent stock market crash of 2008 and withdrew their investments at inopportune times suffering heavy losses. Had they stayed on for the whole of 2008 and continued till now (May 2009) they would have recovered most of these losses and possibly made some gains.
Properly assessing your tolerance for risk is designed to prevent you from making panic decisions and abandoning your how to invest plan mid-stream at the worst possible times. So how do we measure risk tolerance?
Looking at the table it might be possible for you to identify what kind of risk you may be willing and able to take on.
There is another way to approach this. We have seen the how to invest risk/return trade-offs for some investment options earlier. So if you are drawn towards a particular type of investment, you probably have a tolerance for risk approaching that type of investment option. For example, if you are drawn only to FDs and bonds, you risk tolerance is probably the conservative type.
If you drawn to high-quality dividend paying stocks, your risk tolerance probably is moderate. On the other hand, if you are drawn to aggressive growth and momentum stocks, or quality small and mid-cap stock portfolios, your risk tolerance is certainly the aggressive type.
Its important to note that an investor with a "defensive" risk-tolerance can diversify into riskier investments with a portion (say 20%) of the portfolio for better returns, while still maintaining a low-risk profile.
What this boils down to then, is that your risk tolerance profile indicates where the bulk of your portfolio investment could be. However proper diversification across investment categories is essential to ensure a balance between capital safety and growth.
Time Horizon
Now we come to another important how to invest aspect - Time Horizon - or the time you can or will remain invested.
We have discussed in the first article in this series - how to invest: basic investing principles - how Time Diversification, or remaining invested through various market cycles, helps reduce risk. Time diversification is especially useful for highly volatile investment categories such as stocks, where prices can fluctuate over the short term. Staying invested over longer term smoothes these fluctuations.
Because you can reduce some of the risks through time diversification, a longer time horizon allows you to take on greater risks, for a higher return potential. Naturally, with a shorter time horizon you cannot effectively diversify across market or economic cycles, and thus will need to settle for lower-risk, low-return investments.
So, how do we decide on our time horizon -short, long or medium?
Your time horizon is effectively dictated by when you need to take out the money. So if you are investing for a future event such as buying a house, a child's education or marriage - 10 years away - the time horizon, is simply 10 years - the time when you need the cash.
However if you are investing for your retirement requirements - say, 20 years away - when you will need money for periodic withdrawls - the time horizon is simple, till retirement. But when the withdrawls begin, you may need to take out only part of your investment portfolio. Here, the time horizon becomes a blend - short-term, as well as medium to long-term.
And, how do we decide what is long term?
To make the most of time diversification, we have learnt we must remain invested over one complete economic cycle, at the least. In general an economic cycle lasts about 5 years. So a time horizon over 5 years can be considered long term. And longer time horizons over 10 or 20 years works best as they would see through multiple economic cycles. As we have mentioned before, Stocks are a good bet for longer term horizons.
And short and medium term horizons? Well if you need the money within a year or two, you are obviously restricted to the money market funds, short-term fixed deposits and bonds. A medium term horizon of 2-5 years implies you could go in for a mix of medium term bonds and/or high-quality dividend paying stocks. And you will be well-advised to stay out of growth stocks.
Tax exposure
Fortunately in India, there are several tax incentives for investing in stocks and mutual funds (MF). However fixed deposits and bonds are subject to tax, as usual.
Dividends from both stocks and mutual funds are tax-exempt in the hands of the investor. The corporate distributing the dividends needs to incur the dividend tax, of course.
And on Capital Gains, there is even better news. Currently, capital gains from any stock/MF investment held for more than a year (12 months) from date of purchase, is completely tax-exempt again. Capital gains from anything sold within a year is subject to a short-term capital gains tax of 15%.
So the tax structure in India, incentivises you to invest in stocks and mutual funds for the medium to long term and avoid the very short-term.
Life Cycle Investing
As you progress from early career to mid career and acquire more assets and become more financially secure, your risk tolerance may undergo changes. Form a purely growth and capital building requirement, your needs may change to capital preservation. For some part (or a major part) of your investment portfolio you may turn "defensive" and may want to preserve capital first?
Similarly as you grow older and approach retirement your time horizon may shift - you may opt for a mix of short, medium and long term horizon instruments.
We have tried to show an instance of how your investing profile may undergo changes as you go through different life cycle stages. Investment profiles are highly individual. Your own individual profile may be very different from this at any stage. Or, your investment profile may match one of the stages shown here - early retirement for example - but you may be at a different life cycle stage yourself, such as early career.
You need to achive a balance between the risks you are willing to take and the returns you require to achive your financial goals. If you have understood the different aspects of your individual profile well, then you are in a position to assess that proper balance, and create an effective investment portfolio.
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