Find The RIGHT Balance Between Risk And Reward
Amar is a CFA Charterholder and CFP, having over 20 years of experience in IT and Financial Services. He is very passionate about spreading financial literacy and has authored four bestselling books on Personal Finance.
21 May, 2018
“The investor’s chief problem, perhaps his worst enemy, is likely to be himself.” When it comes to investing after finding the right balance between risk and reward, most people are their own enemies” – Benjamin Graham
So, while most of us know ‘Mutual Funds sahi hai’, the lack of knowledge and wide range of choices makes it very difficult to strike a balance between risk and reward.
So how do you decide where to invest your money and trike the right balance between risk and rewards?
Before you start investing your money you should be aware of a few things. You should clearly know the rate of return required to meet your goals. More importantly, you should know how much risk you are willing to take in hard times to earn the returns you require. This will help you avoid more risk than necessary. It is easy to build a portfolio with a good risk-return balance as well as helps you achieve your goals.
To strike the right balance between risk and return you must know what you want your money to do for you and what you want to invest for. When you know your goals and how much money you need to achieve these goals, your approach towards investments changes. You focus on what you are achieving with your money instead of the returns.
People often focus on returns ignoring the risk component. Most of us want an investment with high returns and no risk or less risk. Just like cigarette smokers who choose to ignore the warning ‘Cigarette Smoking is injurious to Health’, investors too look the other way when it comes to the caveat ‘Mutual funds are subject to market risk’.
To understand the returns of funds you should understand the various reasons why one fund earns more than another like –
- High exposure to certain sectors or stocks
- Calls taken by the fund manager have been spot on
- Market timing
However, the same reasons can go against the fund and its performance can suffer. Just because a scheme has been a start performer, does not mean it will continue to be one. Evaluate the performance over extended periods of time and not just over a quarter or so.
Now, let’s focus on your objective of investing.
- Capital Appreciation –
- Income and Capital protection –
If your objective is capital appreciation, then indeed you should look at investing in Equity. Within equity funds, there are various types such as Diversified Equity, Sectoral, Thematic Funds, and Opportunistic Funds. Within this category, a separate classification in terms of market capitalisation of stocks (Large Cap, Mid Cap, Multi Cap and so on) can be done. All of these have varying risks that you must consider.
The core of every portfolio should comprise of diversified Large cap, Multi cap, Balanced and Midcap (depending upon the risk you would like to take) funds. The whole idea of creating a diversified portfolio is to minimise the risk of fluctuation, by adding lower co-related scheme. By lower co-relation we mean, the funds will not move in the same direction in any given market condition. Over a short term, while one category does not perform, and another is performing well, over a long run, the overall portfolio will deliver. This way, we can manage short term volatility and achieve desired returns in the long run.
If your objective is income and capital protection, then a debt fund is more appropriate. Short-term funds that are required in a few weeks or months should be parked in liquid funds or floating rate funds.
Finally, avoid costly mistakes such as chasing star performers of last year and acting on the basis of some rudimentary talk about fund size or promises about unrealistic performance.