Can a low-risk portfolio be a problem? One would think not. Your money is safe and you don’t have to worry about falling values. But what you may be missing is that a low-risk portfolio comes with its own set of problems that may put your goals at risk. Do a forensic evaluation of your portfolio to recognise if there are any hidden risks that you may be overlooking in the effort to keep overall risk low.
Here are some common errors that creep into a portfolio when you select investments with safety as the priority and how you can overcome your fear.
Too many safe investments can put your portfolio at risk
Risk of Loss Not Only Risk
If your goals have a long tenor but the investments are short-term in nature, say in short-term deposits or cash, then you are likely to face the risk of the real value of your savings eroding over time due to inflation. You may find that the corpus will not be adequate to meet your goals unless you are able to top up with additional savings.
“Sometimes taking no risk is the biggest risk of all. By being overly risk averse, you will sacrifice growth in your portfolio. This may lead to a situation where you goals and objectives are not met,” said Priya Sunder, director, PeakAlpha Investment Services.
Another safe investment may turn out to be risky if you cannot access it when you need the funds to meet your goals. Consider a situation where you are saving in a guaranteed product like the Public Provident Fund. Your savings are safe, but PPF’s restricted withdrawal feature may not let you access the money when you need it. This liquidity risk in the investment can push you into debt to fund the goal or you may have to draw on savings for other goals to find the required funds.
Another investment behaviour that could hinder your goals is when you choose income-oriented investments when actually your goals need a growth orientation. Consider an investment made in a periodic interest paying bond like a tax-free infrastructure bond. Unless you develop the discipline and process to reinvest the periodic interest, your corpus will not grow to the amount you need since the interest is being consumed and not reinvested.
Moreover, your investment requirement may become very high if you are risk averse, said Melvin Joseph, a Sebi-registered investment adviser and founder of Finvin Financial Planners. “For example, if you want to create ₹1 crore in 20 years, it is possible by investing ₹10,000 per month in equity funds (assuming a 12% CAGR). But to reach ₹1 crore through debt (assuming a 7% return), the monthly investment required is around ₹20,000,” he said.
In all these situations, your risk aversion is the primary hurdle. Once you recognise this, the next step is to address the source of the fear and find a solution that will allow you to add risky assets to rectify the drawbacks in the portfolio. “Volatility and growth go hand in hand. High growth comes with higher risk. A risk premium is the excess return that an equity investment is expected to deliver compared to a risk-free return such as an FD. Hence, there is a trade-off that an investor makes in terms of the extra risk he absorbs for the extra return he expects,” said Sunder.
Very often it is the fear of loss in the value of the investments that holds you back from earning better returns. You cannot eliminate volatility but you can neutralise its impact on your goals by assigning riskier investments such as equity to long-term goals. Such investments may see variability in values in the short term. With a longer investment horizon, short-term volatility gets ironed out and allows the investment to gain in value over time in line with its fundamental worth.
One of the contributors to the stress of holding volatile investments is the compulsion to check its value regularly. But once you have designated it to a long-term goal, this need is eliminated. Be disciplined about putting in place a review process that will allow you to identify any decline in its fundamental worth that may trigger an exit.
When you have a well thought out process to review the investment, it gives you the confidence that your savings will be protected from the effects of volatility.
Building a Safety Net
Sometimes the fear of the funds not being accessible keeps you from making the most of investment opportunities. The result is that you choose to trade-off better returns for liquidity in investments like short-term deposits. But these will expose you to reinvestment risk as these short-term products need to be rolled over frequently as they mature. You need to deal with the fear of running out of funds to be able to commit your savings to longer periods for better returns.
This confidence will come from creating an emergency fund that is adequate to meet unforeseen expenses. “Before starting investment for long-term goals, create the necessary emergency fund. Ideally, you should have 12 months of living expenses as emergency fund if you have a single-income family. In case of double-income families, six months is enough,” said Joseph.
You should also have a system in place to move the corpus to easily accessible products as the goal comes close. Once these two factors are taken care of, then you should be ready to commit funds to longer term investments where you can earn better returns albeit with some risk.
You may receive periodic payouts from an investment either because it is structured in such a way, for example a coupon-paying infrastructure bond, or because you choose to receive it to reduce the risk as it lowers your exposure. Unless you need the income, not reinvesting the income may deprive you of the benefit of compounding. To de-risk the portfolio, choose the cumulative option in fixed income products where available. Manage the risk of default by keeping a close eye on the credit quality of the borrower and make sure you have an exit option you can exercise if required. The other option is to put in place a process that makes sure the interest income gets invested. Have a bank account dedicated to receiving periodic investment income from which automated investments will be made to chosen products.
Walking the tightrope between risk and return is not easy but can be done when you approach the portfolio in a systematic way. Build it on the basis of an asset allocation aligned to well-defined goals and your ability and willingness to take risk. “You must have the right asset allocation to tide through volatile periods. A sufficient part of your portfolio must be held in safe investments, so your portfolio is cushioned during volatile times. The remaining should be invested in growth-based assets,” said Sunder.
Select investments on the basis of their fundamental strengths and how they impact the risk and return from the portfolio. Start small and add risky assets gradually. A periodic investment plan is a good way to add risky investments, such as equity, to the portfolio. Put the investments on auto mode to get over the starting trouble that is typical of all difficult decisions. Put in place a review process that will help ensure that the investments are rebalanced as the needs of the goals change. Use professional help if you feel that you can do with some assistance.