Investment Objectives & Advice, Mutual Fund

Portfolio Management: 5 point check of risk appetite

“To stay healthy, you should always eat less than your full appetite.” – Unknown

Appetite refers to the quantum of hunger, Risk appetite is no different. Risk Appetite refers to how much risk you can have. Important that higher risk does not mean higher returns, it actually means higher probability of loss. In the recent bull run people, who have not seen the down turn yet do not fully grasp the meaning of risk. One of my known started investing in small caps based on his senior’s suggestion that with higher risk comes higher returns. his senior suggested that small caps are risky but produces higher returns, over last 5 years he garnered ~20% per year returns on his SIP. This prompted my known to put all his money in small caps, today on a YTD basis he is down ~30% and on SIP down ~18% annualized. He stopped his SIP and not do not want to touch small caps for foreseeable future. This is the impact of investing without understanding your own risk appetite. Our bikes are capable of top speed of 100+ but how many of us drive at 100+, i see some people never crossing 40-50 kmph speed limit, because while driving you go as fast as you are comfortable with. Same is true for investing, you should go as fast you are comfortable with.

In last write-up we talking about the risk capacity, approached it quantitatively as it can be measured (Read: 7 ratios to define risk capacity). Today we will talk about the qualitative measurement of the risk appetite, Overall risk profile should be a mix of risk appetite and risk capacity. If risk appetite is more than risk capacity, you should respect risk capacity and in vice versa, you should try to increase your risk appetite but acquiring new skills and making some changes in your plan. As risk appetite is qualitative measure, Let’s quickly go through the 5 main parameters & relevant questions to check our own approach. There is no right or wrong answers but just one answer which rhymes well as your first choice.

  1. Knowledge of financial shenanigans define, how well versed you are with terminologies and understanding the happening of financial markets and its impact on instruments. Terms like Interest rate parity, ROI, ROE, EBITDA, Sharpe ratio, Diversification, Beta, Volatility etc.
    • (a) Understands all these terms
    • (b) Knows some of them and can interpret
    • (c)  Know few terms but can not interpret
  2. Behavior in times of financial uncertainty defines our primary natural response, can you comprehend the difficult choices. What will your investment choice between the below options:
    • (a) 10% chance of -20% return, 50% chance of 8% return and 40% chance of 16% return
    • (b) 50% chance of 3% return and 50% chance of 13% return
    • (c) 8% Assured return
  3. Behavior under stress when you see your money is just reducing day by day, how will you respond to that scenario. If you have invested INR 10 lacs and within a month it falls down by 10%, what will you do:
    • (a) Buy more, as the investment is available at cheaper prices
    • (b) Do nothing
    • (c) Sell it, because you can not take risk to let it go further down and move it to assured return type of investment option
  4. Emotional stability in the time of distress is another important aspect. It shows, how much carefully you have planned your financials as well as what level of self confidence you have on those plans. If you have planned a foreign vacation which is quiet expensive and you were fired from your job just 7 days before that trip, what will you do?
    • (a) Still go for the trip & Decide on the next steps
    • (b) Go for the trip nervously and start applying for the jobs during the trip itself
    • (c) Cancel the trip and start looking for the next job immediately
  5. Lastly, how do you rank yourself on the risk seeking behavior as no once can be a better judge of yours then you yourself.
    • (a) Aggresive
    • (b) Moderate
    • (c) Risk Averse

Score yourself on the above questions; give 1 mark for a, 0.5 for b and 0 for c. If your total score is <2 then you are risk averse while >3.5 you are aggressive risk taker. You should use these parameters of risk appetite, risk capacity (Link), time to your financial goals and market valuation (Link) as parameters to define your equity asset allocation (Read: How much equity should you hold?).

Read more on Mutual Funds & Investment Planning. Happy Investing!!

 

 

Uncategorized

Calculating Taxable Income

There are only two things in life you can’t duck: Death and Taxes

I agree that you can’t duck the first but second part I disagree. We, the salaried people, have to pay our taxes and as a patriotic person we should not avoid to do so. We are generous people and we do charity by distributing money to poor people, we do consider there how much should I give but while paying taxes we don’t. We leave our taxes part to be handled by a tax filing agent or broker, without knowing what he did was that right? We have to do it but still we never plan it. This is to take the first step to know our liabilities in terms of taxes and making us little more educated to plan it accordingly to minimize it, to have larger share to spend by ourselves.

In case of a salaried person our incomes are segmented under various heads. Different companies have different type of salary structures to be followed, but the major components you can find are

  • Basic salary
  • House rental allowance (HRA)
  • Dearness allowance (DA)
  • City compensatory allowance (CCA)
  • Conveyance
  • PF deductions
  • Bonuses
  • Special allowances/ Reimbursements (Cell phone, Travel, Entertainment, Attire, Education etc.)

Not all the components of the salary are taxable and most of the companies try to structure their Employees salary in a manner that company and employees both should get the most out of it.  

Fully taxable components are

  • Basic salary
  • Dearness allowance
  • Bonuses

Partially taxable parts and their treatments are as follows

1.       House rental allowance (HRA): HRA which is deducted for our income tax calculations is the minimum among

  • 50% of the basic salary (In 4 Metros), 40% of the basic salary (In rest of country)
  • Actual rent -10% of your basic salary (In Non metro), Actual rent (In 4 Metros)
  • HRA given by  Company

If the HRA received is more than any other calculations on the remaining amount one have to pay the income tax as per his tax bracket. For e.g. if;

Naresh works in Delhi and his HRA is INR 10,000 pm while his basic salary is INR 22,000 pm and he stays in a rented flat of INR 8,000 pm. Then calculations will be

  • 50% of basic salary à INR 11,000
  • Actual rent à INR 8,000
  • HRA given by company à INR 10,000

Therefore out of actual HRA only INR 8,000 is Non-taxable and extra INR 2,000 becomes taxable.

2.       Special Allowances: Most of the special allowances are based on actual bills and can be treated as Non taxable components for general considerations. But in cases when actual bills under various heads are for less than the amount received then the extra amount is taxable at your end. For e.g. if;

Mahesh is eligible to get LTA of INR 22,000 pa but his cost of travel is INR 12,000 so company pays him his extra eligible amount of INR 10,000 then this amount is taxable as per your tax brackets.

Non-taxable components in ones’ salary are

  • PF deductions
  • Conveyance

Apart from normal salary people have various other sources of incomes which are taxable as per applicable income tax rate these other incomes can be

  • Rent received from house
  • Capital gains on sales of real estate property
  • Capital gains through Investments
  • Income from business or secondary employment

All these are treated differently, for which consult your investment advisor.

Once you know your taxable components we can look for availing deductions under various sections of income tax through investments and repayments which we’ll cover in next blog on Deductions under income tax on 1st Oct, 2010. Till then you can start using income tax calculation sheet after down loading from following link:

http://www.2shared.com/document/PXTsgfLr/Income_Tax_calculations_2010-1.html

the password for the link is eduform1

To use it just fill in the cells in yellow and it will automatically calculate your income tax payable to Govt. at the end of the financial year.