Investing without a plan can expose you to the risk of either not accumulating enough to achieve your investment objectives or losing a part of your capital or both.
Considering that you may have different investment objectives covering varying time periods, you need a specific plan and strategy to achieve them.
Broadly speaking, your investment strategy should guide each of your investments. That is - how much to invest, how to invest - in a lump sum or systematically - and above all - when to sell.
A well-defined investment plan also prepares you to face various challenges through your defined time horizon.
One of the major challenges that every investor needs to overcome is handling volatility in the markets. The surprising part is that though ups and downs are a common part of investing, not many investors have the temperament and the skill to tackle them.
Investors’ reaction to such events generally depends upon the severity of the situation and the duration of period of uncertainty in the stock market.
Remember, volatility is a statistical measure of the tendency of the markets to rise and fall. Someone who has spent time in the stock market would know that volatility in the stock market is a natural phenomenon. Therefore, you must take it in your stride. A knee-jerk reaction can be detrimental to your fortunes.
For example, if you invest in equity funds as a part of your retirement planning, you should not bother about short-term movements in the stock prices. The focus should be on the quality of the portfolio and the right mix of asset classes in it.
Another important aspect of investing is diversification. This aspect not only reduces the risk in your portfolio but also ensures some part of the investment performs well at all times.
Asset allocation helps you diversify your portfolio across different asset classes.
Remember, when you invest in two different asset classes that tend to go in opposite directions in different market conditions, the combination is likely to have a stabilizing effect on your portfolio. Simply put, diversification reduces your portfolio risk more than it compromises your returns.
Therefore, don’t make the mistake of either relying on a single asset class or over-diversify your portfolio within an asset class.
It is quite common to see portfolios that have a large number of funds. The common belief is - more the number of funds one invests in, more diversified the portfolio will be.
It is a myth that investors have been following for years. In reality, in a portfolio that suffers from over-diversification, the returns get diluted as non-performing funds pull down the overall returns. Moreover, the process of monitoring the performance of the portfolio becomes quite cumbersome.
Investors must realize that mutual funds themselves are a diversified investment vehicle. For example, most multi-cap equity funds would have around 40-50 stocks in the portfolio and hence the money gets diversified into a number of stocks, sectors and different segments of the stock market.
Therefore, the right way to assess the diversification level will be from the point of view of the portfolio of the funds one is invested in and not from the the view of one’s own portfolio.
Time diversification, i.e., remaining invested over different market cycles is another important aspect of investing. It helps reduce the risk that you may encounter by investing or selling a particular investment or a category of investment at a bad time in the market cycle. It has much more of an impact on investments that are volatile, such as equity funds.
The length of time you remain invested is important because it can directly affect your ability to reduce risk. Longer time horizons allow you to take on greater risks in order to improve your total return potential. Some of the risks can be reduced by investing across different market environments through a disciplined investment approach.
Time horizons tend to vary over your life cycle. Most of the younger investors who invest to accumulate money for a long-term investment objective like retirement have no real liquidity needs except for short-term emergencies.
However, younger investors who are also saving for a specific event, such as buying a house or a child's education, may have greater liquidity needs at different time intervals.
Similarly, investors who are on the verge of retirement as well as those who are already retired and largely depend on their investment income, have greater liquidity needs.
Last but not the least, we often forget that in a current market-like situation that presents great buying opportunity for a long-term investor, investing in a disciplined can be quite rewarding.
However, investing short term money into equity funds in the hope of making a quick buck can be suicidal. Therefore, if you feel compelled to make a shift to conservative asset classes, look at your investment goals and portfolio mix before doing so.
(Hemant Rustagi is the CEO of Wiseinvest Advisors.)