A Scripbox community member recently asked us, "Why does Scripbox not take my risk appetite into consideration? Your portfolio of funds is the same for everyone. I can take more risk but you don't offer small cap funds for me."
This is an important question and here's what we said.
Most people mistakenly assume that the answer to "where do I invest my money" is a specific mutual fund (or stock). The correct answer is actually made up of 3 progressive decisions:
- Which asset class (Equity, debt or cash);
- Which asset (direct equity/ Equity mutual fund or FD/Debt fund); and only then to
- Which specific product (a specific mutual fund or a specific bank FD).
Scripbox is designed to help you navigate through this decision process.
Decision 1: Which Asset Class?
Your needs determine the asset class to invest in.
When you are investing for the long term, beating inflation is necessary and equity (or stocks) is the right asset class; for short term, the certainty of return and capital is more important and fixed income (Debt funds/FDs) is the right asset class.
As your goals get closer, you need more certainty of having the money at hand. So, if you are planning for your daughter's education in 15 years, you should invest in equity but when she's 15 and college is 3 years away, your money should be in fixed income. This way, when the time comes to pay college fees, you are not affected by the state of the stock market.
Decision 2: Which Asset?
Once you have decided the asset class, for example, Equity, you then need to decide whether you will invest directly in stocks, take the mutual fund route or (if you are a high net worth individual) hire a portfolio manager. Each of these options adds its own characteristics to those of the asset class.
Similarly, if you choose to invest in fixed income, you must choose between bank FDs, debt mutual funds, company FDs, company bonds, government bonds etc.
Your decision will be driven by the returns of the asset relative to that of the asset class, costs, taxes, security, convenience etc. For example, equity mutual funds are superior to other options within both - equity and fixed income - asset classes and that's why Scripbox recommends them.
Decision 3: Which product?
Once you take an asset decision as above, the specific product will usually not vary based on the investor. Everyone's objective is common - to get the product portfolio which best promises to live up to the promise of that asset.
Our recommended mutual fund portfolio is, therefore, the best portfolio for that asset class. It doesn't vary by the investor - everyone's money is trying to get asset class returns. This is also why you should not get attached to the products within that portfolio. They can and do change over time.
“But I can take more risk ...”
Here again, you must understand the concept of asset class risk.
While investing in equity, you have to be prepared for the volatility of stocks. This is the asset class risk which tends to reduce with time in the market but never goes away (Related Reading: How Long Is 'Long Term'?). Once you are prepared for that, there is no further differentiation of risk appetite within the asset class.
Please note that asset class risk is not the same as speculative risk taking. When people tell you (for example) that small caps are riskier and offer a higher return for that risk, they are usually referring to very short term speculative gains.
To support this, people will also often tell you that small caps is a different asset class - in our opinion, it's not.
Reminder: Scripbox only caters to long term accumulative investing and discourages speculative investing.
Note on asset classes
There are 6 asset classes, of which the first 3 are financial asset classes
1. Equity: when you own a business (or part of it). Return on Equity is earned over a long period of time, is unpredictable and fluctuates a lot. Risk comes from business failure. You manage this risk by diversifying your portfolio and focusing on the prospects of the business you are buying into.
2. Fixed Income: when you lend to a business. Return is usually fixed and certain but you run the risk of credit default (business is unable to pay you back). Bank fixed deposits are in this category - you are lending to the bank ! You manage your risk by looking at the credit-worthiness of the entity you are lending to.
3. Cash: when your money earns no return
4. Bullion: Precious metals like Gold & Silver
5. Commodities: Oil, Corn, Wheat and such
6. Real Estate: Commercial or residential property