At the beginning of the year, Tarun invested almost all his savings in the stock market through well-known Mutual Funds. He knew that the markets had already run up but he was investing for the long-term he reasoned. Now after 8 months, his savings are down 10-15% and he is worried that if the market crashes then he will lose much more than he is prepared for. Every day, instead of focusing on his work and family he is now glued to screens of stock market charts and news.
We all know that investing in the stock markets is risky. The recent fall in the Sensex and the accompanying volatility is an illustration of this risk. And no matter what your broker says, this risk cannot be eliminated. If investing in stocks could be made risk-free then the returns would be similar to that of a fixed deposit. The reward of suffering this risk and volatility is that in the long term, stock markets give returns of 15% vs. 7-9% given by Fixed Deposits.
But this is easier said than done. Stock markets fall 10-20% every once in a while and occasionally they crash 40-50% like in 2008 during the global financial crisis. On one hand it is impossible to predict such crashes and on the other hand it is also impossible for anyone to see their net worth drop by over 50% in a matter of months without panicking.
So then how can we invest in the stock market without losing sleep over it? By investing according to our risk tolerance. It is a simple and highly effective tool yet something that almost everyone overlooks while investing.
What does risk tolerance mean?
In plain English, it means roughly how much loss you think you can deal with through your investing period without pressing the panic button. It varies from investor to investor and depends on her nature towards risk, past experiences, income level, financial liabilities, time horizon etc. One simple way to calculate it for yourself is to answer this question – If the stock market loses 50% like it did in 2008, how much % loss would you be okay with in your personal portfolio?
There is no one right answer and while talking to several investors, I have received answers ranging from 0 to 50-60%. As long as your answer is based on an honest introspection, it is correct.
How can you invest according to your risk tolerance?
Say you came up with an answer in the range of 20-30% (a common answer) i.e. you can sit through a 20-30% loss when the market crashes 50%. Now let’s see how we can use this number to start making smarter investment decisions.
They key is to build a portfolio of risky and non-risky investments:
• Risky: Stock market investments like Equity Mutual Funds and,
• Non-risky: guaranteed return investments like Fixed Deposits or very low risk investments like Short-term Debt Mutual Funds which give FD like returns.
Asset Allocation or How much of each should you buy?
If you are okay with a loss of 20-30% then you can allocate about half of your total portfolio to the stock market through Equity Mutual Funds and keep the other half in non-risky investments like FD or Short-term Debt Mutual Funds.
The risky stock market half would move up and down with the stock market, and when the Sensex crashes 50% it will also go down by a similar amount. But the non-risky part will hold steady. So overall in a 2008-like crash scenario, you will lose only 25% (50% of risky-half + 0% of non-risky half) of your total portfolio.
Who uses risk tolerance and asset allocation in the real world?
All sensible investors, from huge pension funds to small but savvy retail investors, invest according to their risk-tolerance. This is the only way they can stay invested through the ups and downs of the market without abandoning their investment plan. In fact a major part of any financial advisor’s job is to ensure that her clients’ money is always invested according to their risk tolerance.