Question

As an investor what are factors of Risk and Return.

Answer 1

question:As an investor what are factors of Risk and Return?

Ans:

1st set of answer as per the US market and 2nd set of answer will be for Indian market scenario

Financial Navigating in the Current Economy: Ten Things to Consider Before You Make Investing Decisions

Given recent market events, you may be wondering whether you should make changes to your investment portfolio. The SEC’s Office of Investor Education and Advocacy is concerned that some investors, including bargain hunters and mattress stuffers, are making rapid investment decisions without considering their long-term financial goals. While we can’t tell you how to manage your investment portfolio during a volatile market, we are issuing this Investor Alert to give you the tools to make an informed decision. Before you make any decision, consider these areas of importance:

1.         Draw a personal financial road map.

Before you make any investing decision, sit down and take an honest look at your entire financial situation -- especially if you’ve never made a financial plan before.

The first step to successful investing is figuring out your goals and risk tolerance – either on your own or with the help of a financial professional. There is no guarantee that you’ll make money from your investments. But if you get the facts about saving and investing and follow through with an intelligent plan, you should be able to gain financial security over the years and enjoy the benefits of managing your money.

2.         Evaluate your comfort zone in taking on risk.

All investments involve some degree of risk. If you intend to purchase securities - such as stocks, bonds, or mutual funds - it's important that you understand before you invest that you could lose some or all of your money. The money you invest in securities typically is not federally insured. You could lose your principal, which is the amount you've invested. That’s true even if you purchase your investments through a bank.

The reward for taking on risk is the potential for a greater investment return. If you have a financial goal with a long-time horizon, you are likely to make more money by carefully investing in asset categories with greater risk, like stocks or bonds, rather than restricting your investments to assets with less risk, like cash equivalents. On the other hand, investing solely in cash investments may be appropriate for short-term financial goals. The principal concern for individuals investing in cash equivalents is inflation risk, which is the risk that inflation will outpace and erode returns over time.

3.         Consider an appropriate mix of investments.  

By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can help protect against significant losses. Historically, the returns of the three major asset categories – stocks, bonds, and cash – have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset category, you'll reduce the risk that you'll lose money and your portfolio's overall investment returns will have a smoother ride. If one asset category's investment return falls, you'll be in a position to counteract your losses in that asset category with better investment returns in another asset category.

In addition, asset allocation is important because it has major impact on whether you will meet your financial goal. If you don't include enough risk in your portfolio, your investments may not earn a large enough return to meet your goal. For example, if you are saving for a long-term goal, such as retirement or college, most financial experts agree that you will likely need to include at least some stock or stock mutual funds in your portfolio.

4.         Be careful if investing heavily in shares of employer’s stock or any individual stock.

One of the most important ways to lessen the risks of investing is to diversify your investments. It’s common sense: don't put all your eggs in one basket. By picking the right group of investments within an asset category, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.

You’ll be exposed to significant investment risk if you invest heavily in shares of your employer’s stock or any individual stock. If that stock does poorly or the company goes bankrupt, you’ll probably lose a lot of money (and perhaps your job).

5.         Create and maintain an emergency fund.

Most smart investors put enough money in a savings product to cover an emergency, like sudden unemployment. Some make sure they have up to six months of their income in savings so that they know it will absolutely be there for them when they need it.

6.         Pay off high interest credit card debt.

There is no investment strategy anywhere that pays off as well as, or with less risk than, merely paying off all high interest debt you may have. If you owe money on high interest credit cards, the wisest thing you can do under any market conditions is to pay off the balance in full as quickly as possible.

7.         Consider dollar cost averaging.

Through the investment strategy known as “dollar cost averaging,” you can protect yourself from the risk of investing all of your money at the wrong time by following a consistent pattern of adding new money to your investment over a long period of time. By making regular investments with the same amount of money each time, you will buy more of an investment when its price is low and less of the investment when its price is high. Individuals that typically make a lump-sum contribution to an individual retirement account either at the end of the calendar year or in early April may want to consider “dollar cost averaging” as an investment strategy, especially in a volatile market.

8.            Take advantage of “free money” from employer.

In many employer-sponsored retirement plans, the employer will match some or all of your contributions. If your employer offers a retirement plan and you do not contribute enough to get your employer’s maximum match, you are passing up “free money” for your retirement savings.

9.         Consider re balancing portfolio occasionally.

Re balancing is bringing your portfolio back to your original asset allocation mix. By re balancing, you'll ensure that your portfolio does not overemphasize one or more asset categories, and you'll return your portfolio to a comfortable level of risk.

can re balance your portfolio based either on the calendar or on your investments. Many financial experts recommend that investors re balance their portfolios on a regular time interval, such as every six or twelve months. The advantage of this method is that the calendar is a reminder of when you should consider re balancing. Others recommend re balancing only when the relative weight of an asset class increases or decreases more than a certain percentage that you've identified in advance. The advantage of this method is that your investments tell you when to re balance. In either case, re balancing tends to work best when done on a relatively infrequent basis.

10.       Avoid circumstances that can lead to fraud.

Scam artists read the headlines, too. Often, they’ll use a highly publicized news item to lure potential investors and make their “opportunity” sound more legitimate. Always take your time and talk to trusted friends and family members before investing.

2nd case is related with Indian Market

Value investing, pioneered in early 20th century, and made popular by legendary investors like Warren Buffet has a common-sense appeal. Buying securities lower than their fair value sounds like a good trade. But it is hardly that straight forward.

First, determining the intrinsic value of a stock is not easy. Equity valuation is as much art as science. Second, value investing recommends eschewing diversification in favour of a concentrated portfolio. This may work well for institutional investors, with fire-power and access to the management. But this approach of investing in idiosyncratic risks can be ruinous for the retail investors who have informational and capital disadvantages.

If we are not investing at the scale of Buffet, we need to adapt our style as well. Factor investing is a proven alternative. It was pioneered in the 70s, supported by seminal academic research. It became popular in the real world following the Great Financial Crisis in 2008. The underlying systematic approach offers two major benefits. First, it allows us to test conventional wisdom. Second, it offers an advantage in diversification. So, what is a factor?

Market theories tell us that returns of any stock can be explained by a set of hidden variables, plus a residual bit unique to that stock. Usually, we take overall market returns as the sole explainer. In this world, the value investor's job is to find stocks with high expected residual returns, assuming valuation measures can capture it. It turns out parts of this residual can be further explained by other fundamental characteristics of the stock. If they are stable and consistent, each of such characteristics can be thought of as a risk factor. In such a world, an investor's job is to identify factors with high expected returns and design portfolios to capture them. This is, in a nutshell, the essence of factor investing. We systematically probe the drivers of the markets, instead of taking concentrated exposure on idiosyncratic risks.

The time-tested factors in the equity market are value, momentum, quality, low volatility, size and liquidity. Each factor tries to isolate some specific characteristics of the market. Value factor, for example, tries to identify cheap stocks with potential, using metrics like book-to-market, earnings-to-price and cash flow-to-price. Apart from fundamentals, factors can be based on macro-economic or even statistical variables. By combining uncorrelated factors, investors can achieve a balanced portfolio. It also opens up the possibility of factor timing - an alpha strategy.

Factor portfolio construction begins with rigorous research. Once we find a measure that significantly explains returns, the next step is to isolate this source. This is done by sorting stocks on this measure and creating a long-short portfolio (market neutral by design). The process is complex. But since it is quantitative, the output is transparent. And since it is scalable, it is cheaper as well. For small investors these days, investable factor portfolios are readily available in the form of ETFs in the developed markets. Expect to see a proliferation of them in the India market as well going forward.

Factor investing is no free lunch, of course. It comes with its own set of caveats. It is a beta strategy with periods of under and over performance. Like most quantitative strategies, it is susceptible to data mining and other biases. But it does not rely on elusive skills to pick the next multi-bagger. The transparent systematic approach does not cloud risks with promises of rewards. Factor investing is now an institutional favorite. Smart retail money will go the same way in the near future.