The title of this case study might take most by surprise. After all, we have been conditioned to believe that while investing, risk is bad. Well, that's not entirely correct. Taking on risk without understanding its implications isn't right. Similarly, a common mistake made is that risk is considered in isolation. The right approach for evaluating risk is to consider it in conjunction with return; what is commonly referred to as the risk-return trade-off.

Another vital aspect about risk is being aware of one's risk appetite and sticking to it at all times i.e. being unambiguously sure of how much risk one can take on and not exceeding the same. Often age is used as a reference point to evaluate one's risk appetite i.e. the older an individual gets, lower is his ability to take on risk. This is at best a thumb rule. At Personalfn, we have over the years interacted with many clients who are retired, but their risk appetite could only be termed as high. Our advice: do not go by such thumb rules.

It's all about your risk appetite

Typically, market-linked investment avenues like equities and mutual funds would find favour with risk-taking investors i.e. ones who can tolerate erosion in capital invested and variable returns in the quest for the opportunity to clock attractive returns in the long-term. Conversely, conservative investors (i.e. ones with a low risk appetite) are likely to opt for avenues like fixed deposits and bonds; these avenues offer safety of capital invested and assured returns. In the bargain, conservative investors are willing to settle for lower returns vis-�-vis those that can be clocked by risk-taking investors investing in what may be called 'risky' avenues (like equity mutual funds/shares).

This case study deals with a client i.e. Ms. Vibha Khare (name changed to protect the client's identity), who required assistance in financial planning.

Facts of the case

Ms Khare was a 22-Yr old single lady i.e. she had no dependents.

She was a salaried individual earning Rs 40,000 per month (pm).

Her investment portfolio comprised only of assured return schemes i.e. fixed deposits, bonds and small savings schemes.

Our observations

Prima facie, the client seemed to be a risk-averse individual, hence the 'equity-free' investment portfolio.

In turn, she had lost out on the benefits of asset allocation. Her portfolio sorely lacked the presence of an equity component, among other asset classes.

Finally, Ms. Khare had fallen prey to a common malady. She would invest in a random and directionless manner i.e. Ms. Khare was yet to set any concrete investment objectives like buying a house property or retirement planning.

The course of action

We started off with a series of discussions with Ms. Khare to better understand her risk appetite and the reasons for the 'equity-free' portfolio. We were surprised to learn that she wasn't a risk-averse investor at all. How did we ascertain that? Well, we asked her one simple question - If she was investing in the stock markets for the long-term, and the stock markets were to fall 20.0% the next day, would she panic? Her answer (and should be for any investor who has monies committed for the long-term to the stock markets) was an emphatic "No".

The reason Ms Khare had steered clear of equity/mutual fund investments was because she didn't quite understand what they were and how they functioned. On the other hand, investments in fixed deposits and small savings schemes were something she was conversant with and had traditionally invested in. Hence, she chose to stick to the same time-tested investment avenues.

This adds a new aspect to our earlier discussion on risk - wherein one fails to invest in line with his risk appetite (in this case take on an adequate degree of risk), on account of lack of awareness.

So here we had a client who had a high risk appetite, but was not taking on any risk at all! The result - a sub-optimal asset allocation, which delivered meager tax-adjusted returns.

Our first task was to impress upon her the importance of asset allocation. Simply put, asset allocation entails investing in various asset classes in different proportions, depending on the investor's risk appetite and investment objectives. The underlying intention is to offset a downside in one asset class, by the presence of another. In Ms. Khare's case, there was a need to incorporate equities in the portfolio.

Also other assets like gold and real estate needed to enter the portfolio in suitable proportions over time. The aim being to convert the portfolio from an assured return-dominated one to one that was aptly diversified across asset classes.

An example will help us better understand the importance and benefits of holding a portfolio that is well-diversified across various asset classes.

Let's assume that we are dealing with a risk-taking investor who has failed to invest in line with his risk profile. As a result instead of holding a portfolio dominated by equities, he holds one that is debt-heavy. Case 1 shows the investor's present asset allocation wherein debt and gold account for 65.0% of the portfolio; this asset allocation results in a weighted return of 7.5%.

Now, let's consider Case 2, wherein the same investor realigns his portfolio to match his risk profile. As a result of the realignment, equities emerge as the dominant asset class. The investor's new portfolio yields a weighted return of 11.7% i.e. an uptick of more than 50% over Case 1.

The noteworthy feature of this example is that, it isn't a case of taking on more risk to clock better returns. Instead, it's a case of realigning the portfolio to match the investor's risk profile and benefiting in the process.

Now let's get back to Ms. Khare's case and her second problem area i.e. not setting investment objectives. Ms. Khare's investment activity was carried out in an "off the cuff" manner. She wasn't aware of the importance of setting objectives before commencing any investment activity. As a result, she was yet to decide on any concrete investment objectives. It transpired that Ms. Khare planned to get married in about 5 years. So there was an investment objective that merited immediate attention - accumulating monies for the wedding. As per Ms. Khare's estimate, she would need (at present cost levels) a corpus of Rs 500,000 to meet the wedding expenses.

We created an investment plan that would help Ms. Khare meet the aforementioned investment objective. Our recommendation to Ms. Khare was that investments be made only in equities. The reason being she already had enough exposure to debt instruments; so to get the overall asset allocation right, incremental monies needed to flow into equities.

Our view to utilise equities was also based on the fact that we had an adequate time frame to achieve the target i.e. 5 years. Equities as an asset class are best equipped to deliver over longer time frames. Finally, Ms. Khare's appetite for taking on risk also contributed to our decision.

Using our Calc, we found out that Ms. Khare could meet her objective by investing approximately Rs 8,123 per month at 15.0% pa.

The next step, which was very critical, was to educate Mr. Khare about what equity mutual funds were all about and how she could benefit by investing in the same. We chose the mutual funds route (diversified equity funds in particular) over direct equity investing. The reason being investing directly in equities is akin to a full-time activity. The same would entail researching various stocks, tracking them closely and making changes in the portfolio, in line with changing market conditions.

A retail investor like Ms Khare had neither the time nor the competence to do so. Instead, by opting for the mutual fund route, she could access the equity markets and also benefit from the services of a qualified and competent fund manager. Our recommendation for Ms. Khare was to start off a systematic investment plan in a few diversified equity funds, which were selected based on a research process we follow at Personalfn.

In conclusion

The striking feature of this case study was the degree of risk that the client was taking on, without being aware of the same. Her investments in assured return schemes (which on the surface seem like "safe" investments) meant that she was deprived of a proper asset allocation and ended up with a portfolio yielding sub-par returns.

Her ad-hoc investment style meant that she was not equipped to provide for any of the future needs/obligations. Clearly in Ms. Khare's case, playing safe was a rather risky proposition. This case only underscores the need for professional and expert advice while investing, lest one errs on the side of caution!

Finally, while it may appear very simple at the end, we recommend that investors who find themselves in a similar situation should not simply replicate Ms. Khare's plan. Rather they must discuss the situation with their financial planner and let him come up with a tailor-made investment solution.

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