Every investor has a different style of investing. What might be the best portfolio for one, may not necessarily be the best for the other. This is mainly because each investor’s profile is unique. The main determinants of an investor profile are age, financial status, and risk appetite. Risk appetite plays a major role while selecting investments. The portfolio of a low risk appetite investor and a high risk appetite investor are poles apart. Low risk appetite investor, in other words, would want a conservative approach as opposed to an aggressive allocation.
What is Risk Appetite?
Risk is the extent to which returns from a particular asset can vary. It refers to an individual’s ability to tolerate market volatility and fluctuations in their investment returns. Risk appetite or risk tolerance level, refers to an individual’s willingness and capacity to accept short-term market fluctuations.
For example, an individual who prioritizes the safety of their investments over high returns has a low-risk tolerance. While an individual who is willing to accept higher risk for the potential of higher returns has a high-risk tolerance.
Financial planners use an individual’s risk tolerance to create a tailored investment portfolio. It is essential for an individual to have a realistic understanding of their risk tolerance before investing.
There are investors who do not worry even by a 25-30% move in their portfolio, while a few get paranoid even with a half a percent deviation. How should investors with low risk appetite invest? Should they have equity exposure? Risk tolerance and Risk-taking ability are two different things. Risk-taking ability depends on age, financial status, family, goals, etc. While risk tolerance is about your behavior during adverse market movements. Investors with low risk tolerance are not necessarily the ones with low risk appetite.
Below are 3 approaches that help low risk appetite investors with their investments:
Approach #1: Do not invest in equity if you cannot digest market volatility
If you are an investor who checks your investment portfolio 5 times a day, and panic with market movements, then its better to avoid equities altogether. Yes, by not investing in equities you are forgoing greater return potential. But, don’t worry, it’s better than mistakes like buying high and selling low.
In fact, short term volatility isn’t a big problem for investors who are early in their investment career. The longer you stay invested the higher the returns would be. Consider a multi-asset portfolio. Though this has some equity portion, your long-term investment horizon would take care of volatility problems.
However, you need to keep in mind that low risk investments come with lower returns. The traditionally safe investments such as PPF or bank FDs come with a lock-in period. These instruments have volatility issues and hence you need to stay invested till your lock-in period expires. Early withdrawals come with additional costs. Good alternatives to these traditional instruments are debt mutual funds. Investing in debt funds should be for a minimum of three years to take advantage of indexation benefit on long term gains. Therefore, as a low risk appetite investor, choose the debt mutual funds, as they earn comparatively higher returns and they are volatile as well.
Approach #2: Invest in equities with that portion of your assets that you do not worry about
If you have some spare cash with which you can invest without worrying about the principal amount, then consider equity investments. Pure equity investments in shares would be a high risk while investing in equity mutual funds would diversify your risk. With these investments, even though you are a low risk appetite investor, you need to stop yourself from worrying about short term market movements. Review your portfolio regularly and assess its alignment with your goals and rebalance accordingly. This regular review and rebalancing will help you keep the asset allocation in check and in your comfort zone.
Also, for your equity investments, try Systematic Investment Plans (SIPs), these help in rupee cost averaging. This way you wouldn’t have to worry about timing the market or worry about the price of the asset. Long term durations are best for averaging out your costs and maximizing returns. Therefore, make sure you are investing through SIPs for longer durations to minimize risk.
Approach #3: Have a goal-based investing approach
Be it for a first-time investor or an experienced investor, the best approach to follow is goal-based investing. Categorize your goals based on duration – short term, medium-term, and long term. This will help you decide on your asset allocation. For all short term goals, invest in low risk funds, while for medium-term you can have around 10% equity exposure. All your long term investments can have a little higher equity exposure as overtime, returns tend to be higher by averaging out the risk.
Therefore, before starting your investment, break down your goals and prioritize them based on time. Even though you have a low risk appetite, investing in equity if it is for the long term, you wouldn’t have to worry about short term market movements. This approach mainly helps for long term goals such as kid’s education, kid’s wedding, and retirement. As you get closer to achieving your goal, you can start reducing your equity exposure.
For assistance in designing a portfolio that would best suit your profile, contact a financial advisor. The best portfolio is the one that lets you sleep peacefully at night.
Frequently Asked Questions
Age, financial standing, disposable income, and time horizon are all factors that can influence an individual’s risk tolerance.
Age: Younger individuals typically have a higher risk tolerance because they have more time and resources to recover from losses. Those nearing retirement age may have a lower risk tolerance due to a lack of time and resources.
Financial Standing: An investor’s financial standing, including assets and liabilities, can also play a role in risk tolerance, with those with more assets and fewer liabilities having a higher risk tolerance.
Disposable Income also affects risk tolerance, as individuals with more disposable income can afford to take on more risk.
Investment Horizon: The time horizon for needing the investment amount back also plays a role. Longer time horizons may provide some room to experiment with risk. In the long term, the market volatility averages out and offers higher growth.
The following are the best investments for low-risk appetite investors:
Debt Mutual Funds
Government Backed and Post Office Schemes like PPF, NSC, SCSS, etc.
Long Term Portfolio
The right mutual funds for your long-term goals with inflation-beating growth plus risk management.