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How to build a portfolio that matches your risk appetite

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By Hemanth Gorur

If you have ever sat down with a financial planner, or even read any of the numerous investment articles that the internet is peppered with, you will be bombarded by an avalanche of so-called investment rules of thumb. You have the '100 minus your age' rule, the 60-40 rule, the 70-30 rule, and so on.

So which rule do you follow if you need to build a balanced investment portfolio? Or any investment portfolio, for that matter? This depends primarily on your risk profile and risk appetite.

Let us first see what risk appetite and 'balanced investment portfolio' mean.

Investment risk and risk averseness of investors
Fundamentally, investment risk is the probability that you will suffer a loss on your investment. Higher risk means higher probability of loss or higher quantum of loss. Your ability to first assess the investment risk and then evaluate how much risk you are willing to take should determine your choice of financial products, investment horizon, and investment portfolio.

For example, if you are a single, young designer earning top dollar salary and have no loan commitments, your definition of what is risky will be very different from that of an older married designer who has a family to support and a home loan to service, so he will be more risk averse.

Investment products themselves have inherent risk so an equity product is certainly riskier than a debt product. Here is where the idea of a balanced portfolio comes in, where you need to choose investment products according to their risk and your appetite for risk, while aiming to maximize your returns. Remember, higher the risk, higher the potential returns.

Building a balanced investment portfolio
Balancing your portfolio essentially means you need to spread your investments across investment categories or asset classes so that the overall risk of your investment portfolio over the long term matches your risk appetite and is balanced by the expected returns.

Let us take four asset classes for illustration: equity stocks, gold, fixed deposits, and government securities or G-Secs. Equity stocks are high risk high return products. Gold gives you moderate returns with little risk over the long term. Fixed deposits and G-Secs fetch low returns but the risk here is almost nil.

Returning to our earlier example, the younger designer may opt predominantly for equity stocks and maybe a few fixed deposits, giving gold and G-Secs a complete miss. With high income and lesser liabilities, she may be willing to shoulder higher risk in anticipation of higher returns, and thus go for an 80:20 portfolio allocation in favor of equity stocks. For her, this is a balanced portfolio for the long term since the overall portfolio risk is in sync with her risk appetite and expected returns.

The older designer, on the other hand, may include a little of everything, tilting slightly in favor of equity stocks as the predominant asset class in his portfolio. His portfolio allocation may read 50:20:20:10 or 40:20:30:10 in favor of stocks, gold, deposits, and G-Secs. He will be aiming to generate moderate-to-high returns but will not want to take high risk at any cost.

Risk profiles and investment horizons
Remember that another investor in a similar profession and similar stage of life may still opt for a completely different portfolio allocation as no two human beings are alike in their risk averseness.

Finally, given the same choice of investment products and the same investor profile, the investment horizon plays a role in determining the allocation. In the above example, if the older designer swere planning for the medium term instead of for the long term, his allocation may tilt more towards deposits and lesser towards stocks.

Building a balanced investment portfolio involves a self-assessment of your risk averseness, how much of risk you are willing to take to achieve desired returns, and an awareness of the investment risk in financial products.

(The writer is co-founder, Hermoneytalks.com)