Use a few simple steps to proactively mitigate your portfolio risk and enhance returns
The announcements of an effective vaccine perhaps signal the beginning of the end of the pandemic that has gripped the world over the last 11 months. The pandemic has changed our perceptions of risk, making it very real and tangible. As we gear up for the ‘next’ normal, we must review our perceptions of risk and apply our learnings to building portfolios that are more resilient. This may be achieved through the following:
Deal with risk: The first step towards optimally dealing with risk is to understand it better. Every investment carries a certain degree of risk, which stems from the uncertainty in the market, therefore, resulting in uncertain returns. While some investments have near-certain returns, others have highly uncertain returns. Correspondingly, every individual has a certain risk profile, which reflects his/her risk-taking ability. The investment portfolio must be well aligned with the individual’s risk profile. When this does not happen, the risk becomes larger than life and compels investors to make sub-optimal investment decisions. For example, if an individual who has a very low-risk tolerance has a portfolio that is highly skewed to equity investments then he/she is likely to make a wrong decision in times of market volatility.
Distil the goals: The main aim of financial planning is to ensure that individuals can meet their financial goals in a simple and seamless manner. However, every goal is different. Some goals are ‘good to have’ like saving for a vacation while other goals are a ‘must-have’ like saving for retirement. Some need to be achieved in the medium term while others are achieved over the long-term. Factors like return requirement, time horizon, and priority of one’s needs will determine how much risk a person can and should take to achieve his/her financial goals. Thus, it is very important to distill each goal and then create a holistic investment strategy to achieve these goals.
Diversification through asset allocation: Investors can choose to diversify their investment portfolios by spreading the investments across several asset classes. This is called diversification through asset allocation. Several studies have shown that different asset classes perform differently in similar market conditions. This means that in a particular investment environment, while one asset class may perform very well another might underperform. By spreading the investments across several asset classes, investors can ensure that sharp movements in any one asset class do not have an inordinately large impact on overall portfolio returns. Diversification also helps to maintain the overall portfolio risk at an optimum level since certain asset classes like equities, traditionally, carry higher levels of risk while others like fixed income carry relatively lower levels of risk. Further, it also helps investors benefit from multiple investment environments while protecting portfolio downside.
Consider staying invested for the long-term: The equity markets are subject to heightened volatility as stock prices react to daily market noise. However, daily stock price movements seldom reflect the true fundamental value of the stock. It is easy to be influenced by this noise and react in a sub-optimal manner. This only serves to increase portfolio volatility and heighten portfolio risk. An ideal way to mitigate the impact of volatility is to stay invested for the long-term. This will not only smoothen the intermittent volatility but also allow the investments to benefit from the power of compounding.
Invest through a Systematic Investment Plan (SIP): SIP is a smart and easy mode of investing in mutual funds as it allows individuals to invest small amounts of money at regular intervals. The frequency can be weekly, monthly or quarterly. It is a planned and convenient mode of investment that can be started anytime and can help in wealth creation for the future. Since an SIP entails making regular investments, it can help smoothen the volatility associated with daily price movements thereby reducing overall portfolio risk.
Risk, if managed optimally, can help create several opportunities for individuals. The good thing is that implementing a few simple steps can help investors proactively mitigate portfolio risk and allow them to enhance risk-adjusted returns.
The author is Senior Fund Manager, BNP Paribas Mutual Fund
DISCLAIMER: Views expressed are the authors' own, and Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.