You would have heard this many a times that your portfolio construction and choices should be aligned to your risk capacity and appetite. While appetite is a qualitative behavioral assessment, Risk capacity is more mathematical in nature. You can assess it based on certain numerical aspects of your own financial status. In our last write up “How much equity should you hold?“, we spoke about four pillars to decide the equity holdings Risk Capacity, Risk Appetite, Time horizon and Market valuations. In the next few weeks we will talk about these parameters in detail and how to rank yourself on these. Before calculating the ratios, you should know about your financial standing. This is defined through 4 major parameters below, Please keep calculating these for yourself to make the process more fruitful.
A. Take-home Salary/ Income: This is an easy parameter, most of the salaried people know their net take home salary as this is what gets credited to your account on a monthly basis. If you are a self employed person, you need to look at your gross income after reducing the professional expenses out of your total revenue/receipts. In case of salaried employees, you just need to make one adjustment for provident fund as your and employee contributions to EPF is your saving only and will be paid out to you therefore should be added back to your net take home salary.
B. Expenses: Some of us are in habit of keeping a good track of our expenses and some might be in habit of writing those on a daily basis. If you do not, then you can asses based on top of your head basis and reconcile it with you cash outflow from your account or statement of your credit card etc. Expenses are classified broadly in two categories:
- Mandatory/ Necessary: These are common household expenses like house rent/ home EMI, house maintenance, Monthly grocery expenses towards grains/ veggies/ milk etc, Utility bills (Internet, Phone, Water, Electricity), Transport expenses (including Petrol, car maintenance, insurance etc). These can be assessed with certain accuracy and ease.
- Discretionary: These are not necessary one but important to unwind ourselves from our hectic schedules. Dining out, watching movies, buying games, books, for some it is un-necessary shopping, short or long holiday trips etc. Most of these will be easy to ascertain via CC but these are not regular so you might need to think broadly in a yearly fashion to calculate these or reach to a correct amount.
C. Savings/ Assets: This is something which is usually not at all tracked by most of the investors. Lot of people are very good in saving but saving for them means, only not-spending and keeping the amount in savings account. They can probably at best go buy LICs after a push from a sales person or do some fixed deposits or Post office schemes. Our parental generations commit the mistakes of just saving and not investing, which we should aim not to repeat (Link). In most cases, we are not aware of our overall assets and should be recorded at-least once in a year. Assets are broadly split into two categories:
- Financial Assets: Assets which are invested in financial markets or with financial services firm are called financial assets. Investments like Deposits, NSCs, Post Office investments, PPFs, EPFs, Mutual Funds, Stock investments, Bonds, NCDs, ULIPs, traditional insurance are all form of Financial assets. The unique feature of financial assets is that they can be liquidated in short period of time at relatively fair market value.
- Real Assets: Assets like real estate, plots, Gold jewelry etc are form of real assets as you can touch and feel these assets vs Financial assets which are just on paper. The challenge with real assets are large ticket size and difficulty to sell in parts, you can not usually sell a room only of the flat you own.
D. Liabilities: This is the amount you have borrowed from various institutes/ people, in form of Credit Card bills, home loan, car loan, education loan, personal loan etc. The credit is so easily available that we often start indulging ourselves in consumption which is not required. This is a common mistake in our generation (link), which traps us in the mediocre life status. Keeping a track of your liabilities is very important.
The benefit of doing this exercise is that you can keep at-least 1 additional person aware of all your Assets and liabilities to help your family navigate the financial difficulties in case of any family emergency. Secondly you are more aware, so have better chances to succeed financially by knowing your limitations as well as short comings, you can change your financial behavior. There are 7 ratios which helps to determine your risk capacity in terms of financial status based on the above details.
- Savings ratio: The more you are able to save, you have more capacity to take risks. usually 60%+ saving ratio is considered to be very good.
- Expense Coverage ratio: High Net-worth compared to your Annual expenses is a healthy sign. Higher the ratio, higher the risk capacity.
- Income Multiplier: Higher net worth compared to annual income is sign of the investment career cycle. Better the multiplier, higher the risk capacity.
- Leverage ratio: As mentioned previously, the lesser liabilities we have the better it is, Though sometimes it make more sense to take loans specially in case of appreciating assets like education/home etc. Liabilities/ Assets are lower the better for risk capacity.
- Liquidity ratio: If you have high allocation to real assets, which are less liquid in nature. it makes it difficult to meet your financial needs in case of emergency. This should be captured in two forms. Financial Assets/ Total Assets & Financial Assets/ Liabilities, higher the ratios better it is for risk capacity.
- EMI Coverage ratio: Total EMIs/ Take home Income should be measured to calculate the pressure of EMIs on financial health. The lower the value better it is for risk capacity.
- Income Stability: This depends on how many households are earning members, if 2 people in family of 4 are earning it is better vs 1 person. There might be cases when all 4 are earning members specially in case of people in their 50s when their kids also start earning. Their risk appetite increases as a household vs common philosophy that with age risk capacity reduces.
Based on these ratios you can assess your risk capacity (Working Spreadsheet; Please fill in the cells highlighted in blue color) and vice versa check how much equity should you hold in your portfolio (Link).