Many people think about investing as gambling or a game. Many are in it believing this, expecting huge profits overnight and many stay out of it considering the risk in this gambling.
Investing is neither gambling nor a game, It’s your own hard-earned money which you wish to grow over time with the help of compounding.
This article will help you in understanding 3 key concepts which you need to learn before starting your investment journey, so that you can make intelligent decisions down the road.
1. Risk Profiling
A risk profile is an evaluation of an individual’s willingness and ability to take risks. Every person has a different tolerance to market volatility or risk based on several factors like his/her disposable income, age, etc.
A risk profile identifies the acceptable level of risk you are prepared and able to accept. Risk profiling helps you as well as your financial advisor to create a specific investment portfolio with an asset allocation correlating to your risk profile.
For example, a person who is risk-averse would rather maintain the value of his portfolio than aim for high or even moderate returns. On the other hand, a person who is prepared to withstand market volatility with the aim to earn exponential returns is an example of a risk-seeker profile.
Risk Profile Evaluation
Risk profile of an individual is often evaluated based on the balance between his/her assets and liabilities. So, if an individual has several assets in comparison with very few liabilities then he will likely be a risk-seeker. On the other hand, an individual whose asset value is not at all substantial in comparison with his/her liabilities, will most likely be risk-averse.
For example, a person with sufficient retirement corpus, emergency funds and no loans can afford short-term market volatility to seek exponential returns in the long-term.
Another large factor in risk profiling is age. As young-investors have a larger time-horizon than the individuals nearing their retirement age, they can afford to take more risk. Larger time-horizon helps in suppressing short-term market volatility.
There are broadly three types of risk profile: Conservative, Moderate & Aggressive.
2. Financial Planning
Financial planning is a step-by-step approach to meet one’s life goals. Essentially, it helps you be in control of your expenses and investments such that you stay in accordance with your long term goals that may include buying a car, buying a house, child’s education, retiring on time, international vacation, etc.
To achieve all this, you need to have an adequate sum of money. More importantly, you need to have that sum of money at the right point of time in your life that is in accordance with your goals.
For example, if you want to build up a corpus of ₹40 lakh for your son’s higher education through investments, you need to grow this amount by the time he graduates. Not a year or two later. You may have several different goals you wish to achieve but to reach them at the right point in life, you need to have a financial plan in place at a young age.
“If you fail to plan, you are planning to fail.” ~ Benjamin Franklin
3. Asset Allocation
Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and commodities. Each asset class has different levels of return and risk, so each of them will behave differently over time.
The main purpose of asset allocation is to balance risk and reward in line with the individual’s goals, risk tolerance and investment horizon i.e., the period of investment.
Why Asset Allocation Is So Important?
Asset allocation is very important because it has a major impact on whether you’ll meet your financial goal in time or not. If you don’t include enough risk in your portfolio, your investments may not earn sufficient returns to meet your goal.
For example, if you are saving for a long-term goal, such as retirement, then you’re likely to include at least some stocks or equity mutual funds in your portfolio.
On the other hand, if you include too much risk in your portfolio, then the money for your goal may not be there when you need it. For instance, a portfolio heavily weighted in stocks or equity mutual funds would be inappropriate for a short-term goal, such as saving for a short vacation.
You can protect yourself against significant losses by diversifying your investments that might move up and down under different market conditions.
Historically, it has been observed that the returns of the three major asset categories (equity, debt and commodities) have not moved up and down simultaneously. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. So, by investing in more than one category, you can reduce the risk of having a major loss.
The practice of spreading money among different investment instruments to reduce risk is known as diversification. By picking the right set of investment instruments, you may be able to limit your losses and reduce the fluctuations of your investment returns without sacrificing too much on the potential gain.
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