Want to avoid disappointment and regret regarding your investments? Know that understanding your investment risk is more important than chasing the returns. Here is why.
The biggest mistake many investors do is underestimating the risk in their investment portfolio. The often-cited adage of the higher the risk, the higher the returns get lost in the excitement of the bull run in the equity market. Risk is conveniently delinked with the returns. And this leads to disappointment and lost opportunities during market crashes.
Why do investors underestimate the risk in their portfolio while expecting significant returns? We believe there are two primary reasons:
1. Not knowing the history of equity markets
2. Conditioned to believe that markets do not fall much after many years of market uptrend
Reading market history is one of the most important advantages an investor can get over other market players. By reading market history one would understand that equity markets can decline by more than 50% once in a decade and stay lackluster for many years. Every time, the underlying reasons can be different but human behavior remains the same – following the cycle of greed and fear.
Investors buoyed by recent success in the market believe it is only the one way up with very little downside risk and underestimate their ability to keep holding when their portfolio value declines by more than 20%. Saying I will be fine with a 20% decline is easy said than seeing your portfolio value decline by 20 lakhs. What if the decline is 50 lakhs on the original portfolio value of INR 1 Crore? Would you be able to sleep well? This kind of portfolio loss has happened many times in the past and for certain can happen many times in the future as well.
How do you limit your losses and stay peaceful in any market situation?
The answer is to add debt & gold to your investment portfolio and reduce your equity exposure to the extent of downside volatility that you can bear on your portfolio. The role of debt is to provide stability to the portfolio and create provisioning to take advantage by investing in market declines. Gold usually moves in the opposite direction to equity and acts as insurance against global uncertainties.
Are you a conservative investor who can’t tolerate more than a 10-15% decline on the portfolio, then don’t add equity exposure of more than 25-30% in an expensive market.
Are you an aggressive investor who can’t tolerate more than a 30-40% decline on the portfolio, then don’t add equity exposure of more than 50-60% in an overheated market.
If you are okay with a 60-65% decline in your portfolio, go all in equity.
By adding debt and gold, you reduce the overall downside on your portfolio to the extent that lets you sleep peacefully at night. That’s why diversification across asset classes is so important.
The role of a good advisor is to help you understand your risk appetite, and the risk in your investment portfolio and design a suitable asset allocation that matches your risk profile. A competent advisor helps you avoid mistakes that many people end up doing. The cycle repeats and every time a new set of investors learn the importance of asset allocation the hard way. The smart ones read history, learn from others’ mistakes and save themselves from mental agony.
After all, there is no greater wealth in this world than peace of your mind.
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Truemind Capital is a SEBI Registered Investment Management & Personal Finance Advisory platform. You can write to us at firstname.lastname@example.org or call us at 9999505324.