Is investment all about Risk and Return or is there more to it? We all keep hearing about investing and its benefits and that for the long term people should invest in stocks because they give higher returns. On the other hand, people tell about investing in bank FDs because safety is important and still others tell about investing in Mutual funds because – ‘Mutual Funds Sahi Hain’. However, not many people know what all the important factors are there which decide what is the correct investment for you. Let’s discuss them.
While investing money most people always think of how much Return they are going to get. This is the topmost reason which leads people to choose the investment channel. Only after getting educated either the hard way (facing loss) or the soft way (getting knowledge through others’ losses or by studying/ research) they understand Risk and start factoring it into their thought process.
However, Risk is tricky – people tend to have knee jerk reactions here. People who have suffered losses, especially smaller investors who don’t really understand much about markets (our dad’s generation generally) run away from all risk and invest in bank fixed deposits.
Another very important aspect of risk is that – there are 2 things that are important while judging risk appetite and often there is a mismatch between the two – the ability to take risk and willingness to take risk.
Ability to take risk
It is generally determined on the income, expenses, savings, age, and other such determinants. Higher-income & lower expenses, age lead to a higher ability to take the risk. A lower number of responsibilities also increase the risk-taking ability of individuals – that is probably 1 reason why we see young people launching new startups.
Willingness to take risk
Willingness to take risk is totally unrelated to ability – in layman’s terms it is the amount of risk of loss a person is comfortable with. Higher the degree of unease a person has for loss, the lesser the willingness. This is gauged in terms of what is the expected return a person requires for a certain level of return. This is different for different people – my brother’s willingness to take risks far surpasses anything under the Sun whereas my willingness would be even lesser than my ability.
While both these are unrelated to each other, however, while investing we should be wary of both and invest according to the lower (of the 2) threshold prescribed by them. This is because if the ability is higher than willingness – self-investment in risky options will not happen and the manager should not do it otherwise in case of loss the conversations will not be harmonious. On the other hand, if the willingness is more than ability – self-investment may lead to unpleasant situations in case of a downturn; the portfolio manager should guide the client to not surpass ability in these situations.
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Other important Factors
We have covered Risk and Return. Now let’s cover other important factors one should keep in mind while zeroing in on the investment.
Time Horizon (when money is needed)
This is an important factor for investment. Unexpected needs can change the return that you get from an investment.
For example, if you buy real estate (a house) but have to sell it due to a money crunch then you might have to settle for not so good return (or even loss in case of an urgent need – distressed sale). Another example can be regarding stocks – while from a long term perspective generally stocks in good companies have proven to be a good option, there are swings in the short term and if money is required during a downturn it can be bad for returns. Some investment options like bank FDs might even provide better returns for longer-term horizon.
Hence part of the money not required for longer-term options can be put for getting higher returns however, emergency funds or money required in short term should be put in low risk and liquid investments even if it provides low return promise.
This is self-explanatory – there may be some legal restrictions and you should always follow law of the land to be on the safe side. For example, there was a ban on cryptocurrency trading in India some time back.
Liquidity refers to the spending requirements. The lower the spending requirements, the more is the risk-taking ability and this higher ability enables a person to aim for higher return investment
Returns on instruments can vary by mere basis points, and most are uncertain at best. However, one thing in life that is certain is that you will have to pay taxes on those returns if tax planning is not good. There are some options that can circumvent these taxes or can push them to a further date (maybe get returns during retirement when salary income is not present so tax outgo is at a lower rate), allowing for compounding of money, etc. After all, investors care for only what comes their your pockets.
There might be some unique investments that you might not want to purchase. For example, some people might not prefer to invest in gambling, non-veg, liquor, tobacco companies, etc. Others might have some religious or other restrictions. Some people might just have a whim – it’s your money and you are allowed to invest it as per your liking.
These were some points that I had studied during CFA studies and thought might be useful for share with others.
Additional factors that influence investment:
Knowledge (of investment product or process)
One should invest (if doing oneself) in products where you have ample knowledge. Blindly trying to replicate what others are doing can hurt you and you will not even learn much about what was the mistake that you made and thereby cannot avoid that mistake in the future.
Apart from the knowledge of the product, many people don’t have the knowledge of how to invest or have easy access to the underlying instruments and thereby are not able to invest.
Believe it or not, even investing requires access – You might need to have the proper contacts or the right amount of capital (and willingness to invest it) to get a shot at investing in that at all. For example: even if you believe that a startup might be the next Google or Apple, you might not be able to invest because of access to the correct people or the amount of capital to gain entry behind those doors.
This was my take on the important considerations in the investment process. Tell me in the comments about your investment process. What is your willingness to take risk? Also, let me know if I should improve upon anything(s) or a topic you would like me to cover in the upcoming blogs.
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