Goal setting and financial planning: as per your risk and return profile

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Remember Coach Dayal and his two players? Let’s look at their scores once more.

Match number

Runs scored by Player 1

Runs scored by Player 2

1

10

55

2

100

45

3

10

35

4

100

45

5

10

50

Total runs

230

230

Average runs scored

46 (230/5)

46 (230/5)

Now, say Coach Dayal is a risk-taker and he wants an ace player for his team, who has the potential to score a century. He would pick Player 1, isn’t it? 

But say he wanted a consistent player who did not pose much of a risk, even if it meant settling for average run scores. In this case, he’d pick Player 2, right?

This is what picking an investment based on your risk and return profile is all about. And in this chapter, we’ll see how you can include this risk-reward analysis as a part of your personal financial planning. After all, the importance of financial planning cannot be underplayed, isn’t it? For individual investors like you, it’s important to make smart investment decisions that factor in your risk and return profile.

Here’s how you can do this. 

Scenario 1: You want stable and consistent returns over the long term

Say you wish to invest your money in instruments that can give you stable returns over the long term. Perhaps you wish to save for retirement, or maybe, you want to grow your investments enough to purchase your dream home 10-15 years from now.

In this case, your return profile is that of a long-term investor. 

But what about your risk tolerance levels? In other words, in the battle between preserving your capital and earning significant returns, which do you prioritise more? Depending on your answer, you’ll fall into any one of the three risk profiles we’ll discuss here.

The conservative investor

If you prioritise capital preservation over earning above-average returns, you’re a conservative investor. So, say you’re presented with these two investment options.

  • One option guarantees capital preservation but gives you moderate returns.
  • The other option has the potential to deliver above-average returns but comes with the possibility of capital erosion.

You’ll choose the former, since it keeps your capital safe. In this case, long-term investments that bear low risk would be ideal for your investor profile. 

The moderate investor

As a moderately risk-taking investor, you essentially want the best of both worlds. You want your capital to be safe, but you also want to earn great returns. Given this risk-return profile, you could pick long-term investments that come with moderate risk attached. Or, you could balance your portfolio by including some high-risk long-term investments and some low-risk long-term investments. 

The aggressive investor

If you prioritise earning higher returns over capital preservation, then you’re an aggressive, risk-taking investor. In your case, you probably don’t mind investing in an instrument that may prove to be risky if it means that there’s the probability of earning significant returns.

So, being an aggressive investor looking to earn returns over the long run, your ideal choice of investments would be long-term investments that are high-risk-high-reward in nature.

Scenario 2: You want quick and steep returns over the short term

Now, let’s assume you wish to invest your money in instruments that can give you steep returns over the short term. Perhaps you wish to buy a premium gadget 3 months from now, or maybe, you want to save up for a dream vacation in the coming year.

In this case, your return profile is that of a short-term investor. 

Let’s now combine this return profile with your possible risk tolerance levels.

The conservative investor

As we saw earlier, you’ll prioritise capital preservation over earning above-average returns if you’re a conservative investor. Here, short-term investments that bear low risk would be ideal for your investor profile.

The moderate investor

If you’re a moderately risk-taking investor looking to earn high returns in the short run, a mix of some high-risk short-term investments and some low-risk short-term investments would be good for your portfolio.

The aggressive investor

In case you’re an aggressive investor who doesn’t mind taking a chance in an exchange for the possibility of earning above-average returns, you’ll find that investing in short-term, high-risk-high-reward investments like direct equity would suit your purpose.

Wrapping up

When you factor in both risk and returns in this manner, personal financial planning becomes much easier. And by picking investments according to your risk appetite and your expected returns, you can even achieve your life goals within the time frame you have in mind. This exercise also proves to be a valuable part of portfolio management. 

What is portfolio management? And how do you go about doing it? We’ll cover all of this in the upcoming chapters. Keep going. It gets even more interesting down the road.

A quick recap 

  • If you prioritise capital preservation over earning above-average returns, you’re a conservative investor.
  • If you want your capital to be safe, but also want to earn great returns, you are a moderately risk-taking investor.
  • If you prioritise earning higher returns over capital preservation, then you’re an aggressive, risk-taking investor.
  • If you’re a conservative investor looking for long-term returns, long-term investments that bear low risk would be ideal for your investor profile.
  • If you’re a moderately risk-taking investor looking for long-term returns, you could balance your portfolio by including some high-risk long-term investments and some low-risk long-term investments.
  • Long-term investments that are high-risk-high-reward in nature are ideal for aggressive investors seeking long-term returns.
  • Short-term investments that bear low risk would be ideal for conservative investors who need short-term returns, while a mix of some high-risk short-term investments and some low-risk short-term investments would be good for moderate investors.
  • Aggressive investors looking for short-term gains would benefit from short-term, high-risk-high-reward investments.
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