Financial Planning is the process of developing a roadmap for your financial well-being from your current finances. It is recommended that one should start planning and managing at a young age in order to achieve their life goals, financial security and create wealth.
Current finance is constituted by income, expenses, savings, assets and liabilities and helps an individual evaluate their current financial state and make investments according to their risk appetite.
Financial Planning covers several aspects such as creating an emergency fund, debt reduction, retirement planning, creating tax efficiency or any goal-oriented fund.
- To meet your short- and long-term financial goals
- To develop a disciplined approach towards savings & investments
- Build Contingency Reserves
- Improved Cash Flow
- Increased Financial Security
- Build towards your retirement corpus
- Peace of mind and composure
How should you do it?
- Determine the status of your current finances: Compare what you currently own and owe, it gives a sense on the state of your current holdings and helps determine the plan based on your risk appetite.
- Jot down your Financial Goals: Financials goals such as long term/ short term goals that you want to achieve and make sure they’re specific.
- Explore different investment options: Today, market is flooded with various investment options right from equity to debt suitable for every individual’s requirements & goals
- Implement the right plan: You need to select the right investment option based on factors such as your goals, age, risk appetite and investment amount. If you are unsure on the funds you need to select for your portfolio, you can avail the services of a financial advisor. They also help with other aspects like insurance, retirement planning, estate planning and taxation.
- Keep track of your investments: A regular review of your investments helps increase in possibility of fulfillment of your goals. It is recommended that one should review their portfolio once in every month.
A portfolio is usually made up of investments made across multiple asset classes to meet the investor’s requirement of growth, income and liquidity. The process of balancing risk and reward by allocating funds across assets according to an investor’s goals, risk and investment horizon is Asset Allocation. It is one of the most important decisions that an investor makes as it helps determine the allocation among various asset classes to achieve his financial goals. The ideal asset allocation is subjective and varies from person to person based on their investment goal, risk appetite and investment horizon. In some cases the same person saving for a car and a corpus for retirement will pick up different asset allocations as the time horizon for both differs.
It is a known fact that it is impossible to determine which one asset class will the best performing in the given year, in addition, putting all your eggs in one basket by investing in one single asset class can prove to be risky. This is where Diversification comes in, investing across multiple asset classes has the dual advantage of having exposure to the better performing asset classes in the portfolio which in turn will help protect the returns of the portfolio from the poor returns in other assets.
- Asset allocation tries to balance risk by dividing funds across various investment assets
- Asset allocation is Individual specific
- Investors should periodically check their asset allocation and rebalance as needed
Portfolio Selection theories
- Modern Portfolio Theory
The Modern Portfolio Theory as proposed by Harry Markowitz, and William Sharpe helps to identify the ideal portfolio for each investor. An investor can reduce portfolio risk simply by holding combinations of instruments that are not perfectly positively correlated. In other words, investors can reduce their exposure to individual asset risk by holding a diversified portfolio of assets. Diversification may allow for the same portfolio expected return with reduced risk. These ideas have been started with Markowitz and then reinforced by other economists. The MPT can be used to determine optimal portfolio weights with certain subset of all investible assets and an efficient frontier can be constructed with the following inputs (expected return, standard deviation, correlation) for the selected assets.
- Mean Variance Optimization (MVO)
The fundamental goal of portfolio theory is to optimally allocate the investments between different assets. Mean variance optimization (MVO) is a quantitative tool which will allow to make this allocation by considering the trade-off between risk and return. In single period MVO the portfolio allocation will be for a single upcoming period, and the goal will be to maximize the expected return subject to a selected level of risk. Single period MVO was developed in the pioneering work of Markowitz. In multi-period MVO, we will be concerned with strategies in which the portfolio is rebalanced to a specified allocation at the end of each period. The goal here is to maximize the true multi-period (geometric mean) return for a given level of fluctuation in the market/portfolio.
- Efficient Frontier
The efficient frontier is a concept in modern portfolio theory introduced by Harry Markowitz in 1952.It refers to investment portfolios which occupy the ‘efficient’ parts of the risk-return spectrum. It is the set of portfolios which satisfy the condition that no other portfolio exists with a higher expected return for the same level of risk represented by its standard deviation. The Efficient Frontier line starts with lower expected risks and returns, and it moves upward to higher expected risks and returns. So people with different Investor Profiles (determined by investment horizon, risk tolerance and personal preferences) can find an appropriate portfolio anywhere along The Efficient Frontier line. The Efficient Frontier flattens as it goes higher because there is a limit to the returns investors can expect.
- Black Litterman Model
The Black-Litterman model enables investors to combine their unique views regarding the performance of various assets with the market equilibrium in a manner that results in intuitive, diversified portfolios. It seeks to overcome problems that institutional investors have encountered in applying modern portfolio theory in practice. MVO is sensitive to input parameters and tends to produce concentrated and unintuitive portfolios if the parameters are naively specified. To overcome the difficulty of applying MVO in practice, the Black-Litterman model was proposed. This model applies a technique that derives expected return parameters from equilibrium returns and manager views. It largely mitigates the optimizer’s sensitivity problem and enables it to produce diversified and intuitive portfolios. In addition, the Black-Litterman model provides a flexible framework to express views about asset class returns, which ultimately will be reflected in the asset allocation.
Risk profiler is a framework designed to evaluate the investor’s experience and sensitivity to losses both at the time of market decline and subsequent periods. Getting an accurate risk profile for an investor is critical as it will dictate the investor’s risk rating and ultimately the investment strategy pursued with the objective of achieving their financial goals.
Financial risk analysis is measured using 4 parameters:
- Risk appetite: This measures the investors understanding of the concept of risk and how it applies to their life and financial matters.
- Risk capacity: This seeks to explore how much volatility an investor is prepared to absorb and observe.
- Risk Tolerance: This quantifies the degree of variability in investment returns that an investor is willing to withstand.
- Risk Perception: it is necessary to be assess this parameter to ensure that investors are aware of their own risk perception. An investor looking for high risk and high return would normally tend to have low risk perception and vice versa.
Alphaniti Risk Profiling Process
The questionnaire provides a basis for in-depth conversation about the investor’s knowledge, background, and provokes discussion about reasonable investment objectives. Typically, while deciding on where to invest, investors are not very specific about their objective – for example, when discussing their objectives, many investors want to get high returns, but they expect the investments to be safe and liquid as well. For solving this practical problem, the questionnaire-based methodology helps to calculate the objective with the appropriate risk profile.
Here’s a glimpse of the Alphaniti Risk Profile questionnaire:
- What is your age?
- Which of the following best describes your investment purpose?
- What is the duration you plan to invest for?
- Please select your current income bracket:
- Please select the option that best describes the number of dependents you have:
- If Portfolio falls greater than 30% – How are you likely to act?
- What is the worst loss you have seen in your portfolio till date?
Based on the responses selected by the User, the platform generates a risk score and categorizes the User into one of the following categories:
- Very Conservative
- Very Aggressive
- A risk profile is an evaluation of an investor’s willingness to take risks, as well as the threats.
- A risk profile is important for determining a proper investment asset allocation for a portfolio.
- Risk should not be evaluated in isolation, instead Investors should see it as trade-off between risk and return.