Writing on a blog every week is quite refreshing and tedious at the same time. At one point your are full of ideas(you want to write about) and the next moment you are caught up with office work and then desperately searching for time to write. Nevertheless its refreshing and I am enjoying it thoroughly. The reason I am sharing this with you(my readers) is because I was absolutely clueless about the response I would get for friday financials when I started writing. Mind you! I'm no professional writer hence crossing 1000 page views in 15 weeks for my blog (this week) is a great achievement for me.
THANK YOU for the over whelming response.
A couple of weeks back, in response to an earlier post on friday financials I had received a query from one of the readers. Instead of replying directly to the same I will try to answer it through this post(a lenghty answer).
Here is his query..
"Could you please elaborate on how different assets come with varying combinations of return, risk, liquidity and throw light on the desired holding period of each asset class."
Different assets have their own role to play in one's Financial Portfolio and various aspects like return, risk, liquidity come with it. So, for example, if you consider a product like PPF which falls in the debt asset class, it is a 15 yr investment with great(tax free) returns, low risk and limited liquidity. Although it might assure you of a certain future value, simply directing all your saving towards this product might help you in your long term goals but surely will not for goals having shorter time horizon. Hence you need to strike a balance between different asset classes to meet your short as well as long term financial goals.
I have already written about asset allocation in my earlier posts, so today its time to look at your investments with a different(psychological) perspective. This is where risk profiling comes in.
When you see your money increase or decrease it has direct relationship with your emotional state. If your money keeps increasing, you will feel excited, and on top of the world, and when you see it decrease or going down day by day you will feel anxious & despair on your investment decisions. Our emotions guide us in our day to day life, and they are very helpful in your financial life too.(to determine risk)
What is Risk Profiling?
Risk profiling is a process of finding the optimal level of investment risk for you considering the risk required, risk capacity and risk tolerance, where:
1. Risk required is the risk associated with the return required to achieve your goals from the financial resources available.
2. Risk capacity is the level of financial risk you can afford to take, and
3. Risk tolerance is the level of risk you are comfortable with.
The first two aspects of Risk profiling are addressed by financial planning whereas Risk tolerance is a psychological characteristic which is best determined by way of a psychometric test.
The way savings are accumulated can also provide clues as to what the risk tolerance level of an individual is. One way savings can be accumulated is through a passive means, like an inheritance or a lump sum payment from a lottery, litigation, bonus or unexpected dividend. Savings can also be accumulated using an active means, such as business which takes substantial risk taking and effort. Thus, the willingness to participate in risky activities is usually much higher for entrepreneurs and active capital accumulators.
For individuals who have accumulated wealth through passive means or saving (delayed consumption), investment risk may not be very appealing because they may not understand the concept of risk and commensurate return. Moreover, these individuals may not be confident that they can earn this wealth back if they experience steep losses.
Age is often used as a factor in determining one’s risk tolerance. More often than not, younger investors have longer to recover from temporary losses, so they can stomach higher market volatility. John Bogle, the founder of Vanguard, along with many other asset allocators, recommends(as a thumb rule) that one should equate the % of fixed income in a portfolio to one’s age, or equate the % of equity in a portfolio to one’s age.
Risk profiling consists of knowing one’s sources of income and capital, perception of wealth, and career stage or age. All of these factors can help one judge his or her risk tolerance.
To be continued.....
Ninad Kamat
CERTIFIED FINANCIAL PLANNERCM
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