The year 2013 has given every investor one big lesson — that all assets classes can be in the red at the same time. In July and August, all the three asset classes — equity, debt and gold — suffered a hit. If you revisit 2008, when the world economy was in shatters and equity markets were tanking, debt as an asset class was in green and and investors had put in money there.
So, what approach should an investor take to generate returns and achieve his goals? Asset allocation is the answer and one of the important elements that goes into deciding it is the risk appetite of the investor. This is one area that you hear about, but rarely apply mind to.
Understanding your risk appetite
An investor must do a risk profiling and, based on that score, determine his risk appetite. When one carries out the investment for a particular goal, one needs to understand factors like existing investments, asset allocation, returns generated on existing assets and liquidity fulfillment from existing assets. With all these factors in mind, one should carry out fresh investments based on time horizon, liquidity needs and expected rate of return.
Now, suppose your risk profiling reflects that you are a conservative investor and you need to allocate a higher proportion of investments towards the fixed-income group. Also, you will have to do it by increasing your investing horizon. What will you do in such a case? Secondly, if risk profiling reflects that you are an aggressive investor and need to allocate a higher proportion of investments towards equities, this will reduce your time horizon because of an anticipated higher rate of return. What will you do in such a case?
There is no right or wrong answer to the above situations. It purely depends on how you would like to make asset allocation based on the risk profiling, which is a tool to understand an investor's inherent risk-taking ability. However, if you need to adapt, then you need to revisit it.
Depending on your need, you should actively revisit the risk. Do remember not taking a risk is also a risk. And if you need to achieve your goals, risk profiling needs to be considered in this perspective.
For case 1, if the time horizon cannot be changed, you should reconsider the asset allocation and increase it towards equity. Or, you should increase your time horizon or the