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Appetite for risk

A look at the first of the seven immutable laws of investing...


EVEN CASUAL observers of the Indian capital market would not miss the present bull run. Let us leave the theories on what is driving it and how long it will last to the academics. The important thing for an investor is the strategy he should follow. Should he woo higher rewards by exposing himself to greater risk? Or bail out discreetly? Or choose the middle path, booking partial profits and hedging the risks?

No prudent investor would like to commit grave mistakes that he would live to regret. What are the pitfalls to be avoided when one is playing in a bull market? Are there golden rules?

In the forthcoming few instalments, we will look at this aspect by discussing the seven immutable laws of investing propounded by market mavens.

Law 1: Know Your Appetite for Risk

The cornerstone of your policy should be your perception of the risk you can take. And that is determined by several personal factors - such as your age, station in life, marital status, financial position, your core assets (such as a house and car), number of years left for earning, technical acumen in the financial market and the time you have for `research' into companies. Those who are entirely averse to risk should steer clear of the stock market. However, this does not mean that those who can absorb losses should go the whole hog. Even though equities may be outperforming the debt substantially, it will not be wise to put all your investments in equities.

Investors should allocate assets among various asset classes - primarily equities and debt. The ratio would, of course, be determined by the risk appetite, but a 20-80 ratio is considered healthy. If your forecast is that equities are poised to surge ahead, being overweight by about 5-10 per cent, but not much more, in equities may be justifiable.

More importantly, it is important to review the portfolio values periodically. In bullish times like these, as the value of equities tends to rise faster, the equity component of the portfolio may become disproportionately higher. In such an event, we must downsize the equity portion by selling off part of the appreciated stocks and revert to the original allocation. This will help in guarding asset values when the markets start falling. This exercise of rebalancing the portfolio to adhere to the stated allocation plan should be an ongoing one.

Similarly, we must understand that with every major change in any of the parameters that determine your risk appetite, the pattern of your investment allocation would need to be reviewed. For instance, your risk-bearing capacity as a bachelor will be much more than when you get married and have a family to fend for. Or, if you get promoted and the new position brings with it the need to undertake extensive travel or bringing work home, the time you can spare for `research' shrinks, impacting your appetite.

Reallocation of portfolio with a smaller component of equity is just what the doctor would order.

MIDAS

Illustration: Manoj

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