As the global economy is on the verge of a rapid recovery after the successful distribution of a Covid-19 vaccine, investors are once again turning to their wallets. Those who weathered the spring downturns were rewarded for their patience as the rapid economic recovery prompted many new investors to start buying stocks for the first time.
Whether you’re a long-time investor or just getting started, here are the steps you can take to prepare your investment portfolio for the new normal.
Step I: Assess Your Risk Tolerance
In terms of investing, risk is the degree of uncertainty or possible financial loss you incur when making a decision about money. Even keeping your funds in cash is a risk, as inflation can slowly decrease your purchasing power.
Usually, risk and reward are inversely related. The more risk investors take, the higher the potential returns they expect. Typically, individual stocks carry a higher risk than government securities; cash carries little or no risk other than the potential loss of purchasing power over time. To reflect their higher level of risk, stocks have higher potential rates of return than government securities, which offer lower returns but much more stable values.
Before determining which investments are ideal for your portfolio, you should first assess your tolerance for risk. This will determine the percentage of each type of asset, such as stocks or government securities, in which you could invest.
There are four main factors that can affect your tolerance for risk:
- Ability to take risks. It is simply your ability to take risks and is influenced by your current income, your current loans and other debts, and to some extent, your age. Generally, a young person with high income and little debt should be able to take higher risks.
- Need to take risks. Whether you need to take risks depends in large part on your financial goals and the rate of return required to achieve those goals. So, if you want to make a down payment on the purchase of a home in 5 years, you may need higher returns on your investment and therefore take higher risks.
- Willingness to take risks. This is a behavioral factor that is not as easily quantifiable as the previous two. Willingness to take risks primarily refers to your ease with taking risks.
- Temporary horizon. The investment time horizon plays an important role in determining your ability to take risks. As a general rule, the shorter the investment horizon, the lower the ability to take risks. For example, suppose Meg has a 6 month investment horizon while Shawn has a 3 year investment horizon. All other things being equal, Shawn may take more risks than Meg.
Based on an analysis of the above four factors, your risk profile can be broadly categorized as aggressive, moderate, or conservative.
- If you have an aggressive risk profile, you should allocate around 80% to stocks and around 20% to bonds.
- If you have a moderate risk profile, you should allocate around 50% to stocks and around 50% to bonds.
- If you have a conservative risk profile, you should allocate around 20% to stocks and 80% to bonds.
Once you’ve determined your tolerance for risk, you can build your portfolio with investments that complement your risk profile.
Step II: Diversify your investments
Your next goal should be to build a diversified portfolio that provides you with optimal returns while protecting the corpus from unwanted eventualities.
As last year made clear to us, we can never be sure what the future holds. Thus, it is imperative that your investment portfolio is adapted to withstand the uncertainties and the curveballs thrown at you. You can achieve diversification and minimize that risk by investing in a wide variety of investment types and companies.
This way, if a business or business sector is particularly hit by the market, other investments will hopefully help sustain it and reduce the total money you are wasting in the short term. This prevents a single investment in your portfolio from having a significant impact on the risk and overall returns of the portfolio.
Step III: Allocate your assets wisely
Asset allocation is the percentage of each type of investment you hold in your portfolio and is the key to optimal diversification. Asset allocation is influenced by factors such as:
i) Your expectations for returns
ii) Your risk profile
iii) Your investment horizon
For example, if you have an aggressive risk profile, are looking to generate high returns, and have an investment horizon of more than 10 years, your portfolio allocation might look like this:
- 80% to equities
- 15% to bonds
- 5% to cash or cash equivalents
However, this is a very simplistic view of asset allocation. Ideally, you would consider a full range of investments and diversify your portfolio between two or three investment options, such as an equity fund, a bond fund, and maybe an international equity fund.
Step IV: Track investment performance and invest regularly
After assessing your risk profile, diversifying your portfolio and deciding on the best asset allocation option available to you, you need to monitor the performance of your investment.
Periodically reviewing your portfolio’s performance helps to ensure that you are on track to meet your financial goals. If the portfolio’s performance is below expectations, then you need to analyze and identify the reason for said underperformance.
Ask questions like:
- Is it because of factors beyond your control, such as a general economic downturn?
- Is the underperformance temporary?
- Is the underperformance due to short or long term factors?
By monitoring your investment performance, you can correct the situation in a timely manner. However, you don’t have to rush to respond to underperformance. For example, stock markets are volatile, and as a result, equity investments may experience periods of underperformance which could impact your portfolio returns.
However, selling your investments in stocks and switching to bonds may not be the best decision if this underperformance is temporary, as you could miss their payback and also lock in the accumulated losses.
Plus, regular and disciplined investments can ensure you stay on track to achieving your financial goals. By investing regularly, you can benefit from the average cost in rupees. Simply put, when you invest regularly, you are buying at all levels of the market, which helps lower the average cost of purchase.
Investing regularly also takes away the burden of trying to time the markets and buy from the low in the market.
Step V: Rebalance Your Portfolio
A periodic review also helps you assess whether you are sticking to your asset allocation strategy. Without regular tune-ups, your portfolio could become too aggressive or conservative for your risk profile, which can actually reduce the likelihood of you hitting your goals.
If stocks are having a good year, for example, the value of your portfolio will likely increase to reflect a higher value of stocks. Then, if the performance of the stock market weakens, your portfolio would lose a larger percentage of value than you would like.
Likewise, if stocks fall, the value of your portfolio may tilt towards safe instruments like government bonds. While it might seem counterintuitive, you might want to sell bonds to buy more stocks in order to keep your long-term returns on track. Too conservative a portfolio could prevent you from reaching your financial goal – you won’t see the same level of return when the market rallies if your portfolio is too conservative.
You may be wondering when to rebalance. The following situations may cause you to consider rebalancing your portfolio:
- If your asset allocation has drifted due to sudden movements in an asset class. Usually a drift of more than 20-25% would trigger a rebalance.
- If you’ve strayed from your asset allocation strategy for more than six months. If you have achieved a goal and need to exit from an investment or switch to a safer investment.
- If there is a change in your risk tolerance or your personal situation.
The bottom line
Whatever your investing experience, now is the time to make sure that your investment portfolio matches your goals, your timeline, and your willingness to take risks.
When making your plan, remember that volatility and uncertainty can be opportunities rather than barriers to investing. A good investment strategy takes these moments into account to position yourself to build wealth.