In Part I of this article, we looked at the different types of risk. We understood systematic vs unsystematic risk and saw examples of specific risks in terms of our economy’s situation today.

Now that we’ve familiarized ourselves with the risk part of the equation, it’s time to look at the happier side. Reward.

The Iron Stomach Test

Newton’s 3rd Law of Motion states that every action has an equal and opposite reaction, and he was right. In finance (assuming you are a rational investor), you will only take a very big potential risk, if you know your potential reward is correspondingly big. If you take a very small risk, then as a rational investor you should know that your potential reward is going to be correspondingly small.

If somebody comes up to you and says ‘Hey, invest Rs. 1 lakh today and at zero risk and full capital protection, I will give you Rs. 2 lakhs back in 1 year’ i.e. a 100% return with 0% risk, you should turn around and walk away. The risk and return figures are grossly incommensurate.

Taking on some risk is the price of achieving higher returns than those offered at the ‘risk free rate’. Your goal should be to find the optimum balance - the level of risk that you can handle without sleepless nights, that will help you achieve the level of return you require to build a corpus for your financial goals. It's true that if you need high returns, you are going to have to learn how to handle high risk i.e. potential high volatility - hence the term ‘Iron Stomach’.

 

How does your goal time horizon help develop an Iron Stomach?

Yes, investing is about risk, but equally, it’s about your investment’s time horizon.

How do you decide what to invest in? By knowing how long you’re going to stay invested.
If you’re a trader, or a punter, and you’re in one day out the next, your risk is high and returns are a gamble. But there’s one rule of investing that everybody must follow.

The Golden Rule of Investing

Warren Buffet once said: ‘I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years’.

That’s time in the market.
While you aren’t expected to take this literally, what you should take away from this is that if you’re looking for excellent growth, you’ll need to buy and hold. You cannot time the market. And this brings us to the Golden Rule of Investing.

3 things you must remember before investing: Your Risk Tolerance, Your Goal Time Horizon & Your Goal Priority.

It's not just about risk. You could be a high risk taker with a goal that is happening next year. It would in this case, be unwise to invest into equity to build a corpus for this goal.

Extrapolating from this point, suppose you have a short term goal, say - buying a car - which you want to achieve in the next 2 years, equity will not serve you well. The risk involved in equity investing lends high volatility to your investments, and fluctuations in prices can often find you at the wrong end of the stick when you need to redeem the investments and buy the car.

For a less than 3 year goal time horizon, stick to debt.

Now suppose you want to buy a house and you’d like to do this in 5 years, and need to build a corpus for the down-payment for the home loan you’re going to take, you can consider investing in a mix of equity and debt investments. Your ideal investment corpus for this goal would be some fixed income instruments with high interest rates, and a mix of MIPs and balanced funds.

Also, suppose you have to fund your son’s post graduate education in 10 years, you can increase your equity exposure (say 75% equity, 10% debt and 15% gold).

The longer the time horizon, the more you can seek growth by expanding your equity exposure.

The sooner you start, the more time you’ll be able to spend in the market, and the potentially higher your goal corpus will grow to be.

Conclusion

It's common sense.

 

1. There are different types of risk, and you should be aware of which type of risk your investment is going to be exposed to.
2. Risk and return are correlated, the higher the return you are seeking, the more risk you can expect to deal with.
3. Equity investing is risky, but with more time in the market, the likelihood of your investing giving you handsome returns goes up. Debt is comparatively less risky, and so the investment can be of a shorter time horizon. If you have a short term goal, that means less time and that means debt. And vice versa.



 

Keep this easy information in mind, and you’ll be able to sleep well at night.

Add Comments

Comments
xiongjl0502@sina.com Feb 24, 2012 I like your list of good aierclts; actually, all are very useful. I like one of the article the most and that is "Keep Your Financial Strategy in Good Times". Your post is the resource of useful aierclts.
pfeakins@norfolkacademy.org Jan 19, 2012 Now I know who the brainy one is, I'll keep looking for your posts.
julyan@sportcanterbury.org.nz Jan 19, 2012 Thanks a lot - your answer solved all my problems after several days struggling

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