Characteristics of the Types of Investor in Stock Market
The key to successful investing is chalking out an investment strategy that is in sync with your risk appetite. Simply put, your risk appetite is your tolerance to bear losses. Your risk appetite may be low, medium or high. Therefore, to begin investing, you need to understand your risk appetite first to understand what type of an investor you are. This is what will determine your investment profile and help you achieve your financial goals.
There are different types of investor profiles hence, while each individual has a different investment profile and investment preferences, it is easy to classify investors into three broad categories based on the amount of risk they are willing to take.
Here are the three types of investors based on their risk tolerance:
The conservative investor
The first and foremost concern of this type of investor is the protection of his capital. He is unable to bear any erosion of the principal amount he has invested. This makes him a low-risk investor who will probably get sleepless nights during a volatile period in the markets.
What he prefers
A low-risk investor is therefore likely to be happy investing in debt instruments. Since he is not aggressive in his expectations, he does not mind the likelihood of moderate capital growth with steady returns.
The balanced investor
This is someone who is willing to take a little more risk to enhance the value of his portfolio. He will thus have more tolerance for volatility than a conservative investor, but will not be willing to invest in high-risk instruments for greater returns.
What he prefers
A medium-risk investor seeks a balance between stability and growth. His portfolio will consist a mix of debt for stability and equity-oriented instruments that invest in stable companies.
The aggressive investor
As the name suggests, this is an investor who can take the market’s short-term volatility in his stride. He is not afraid to expose his portfolio to high risk in pursuit of higher growth. The essential difference between an aggressive investor and low and medium risk investors is that he is willing to take greater risk.
What he prefers
An aggressive investor is willing to expose his portfolio to high risk instruments in the equity markets and may even bet on unknown companies to further enhance the value of his portfolio. Such investors with a competitive investor profile are also willing to opt for leveraged products such as derivatives of equities and other asset classes.
To identify your investor profile it is important to determine what kind of an investor you are before you embark on your investment journey. It is important to bear in mind that wealth creation is a time-consuming process and staying invested will bear fruit if you have time on your side. Thus, it is wise to invest according to your own risk profile. This is what will take you closer to your financial goals.
The best part about different investor types is that every individual begins as a novice and gradually progresses to the next consecutive level of investment accomplishment through training and knowledge.
Irrespective of the type of investor you are currently, moving on to the next level is not too far, and can be easily done with a little practice and education.
What is the key to being an experienced investor? As can be seen from various examples around us, the most successful investors have excellent temperament that has helped them consistently outperform the market. They can do this not because of perfect timing or hordes of cash. They do it by distinguishing their instinctive tendencies, established methods, doctrines, and laying down a disciplined plan of action.
Taking a cue from Warren Buffett, he says, "Success in investing is not associated with one's I.Q." At the end of the day, what one needs is the temperament to restrain impulses that usually get most people into trouble.
Disclaimer: Investments in the securities market are subject to market risks. Read all the related documents carefully before investing.
Risk is not just about loss
People usually associate risk with stock markets and losses. But risk is a far deeper concept than just loss. It is a challenge to understand and managing the risks associated with investing.Risk AssessmentTo understand your risk appetite, it is important to conduct risk assessment which means to first assess your needs and financial goals. Then, you can assess the various types of associated risks. To understand what is risk assesment, let’s consider an example - you need to withdraw money from the investments you have made during an emergency. But your money is locked in. This is when you run the risk of lacking liquidity. Although there is no technical loss of money, it is still a disadvantage you stand to face at important times. This can thus be considered a risk too.Thus, to maximize your investments, understand the various types of associated risks and create a risk management plan.Type of risks in investing: Before understanding other types of risks, look at what market risk refers to: • Equity risk: This is the most obvious form of risk wherein the equity investment rises and falls. But remember, equity risk is only one of many types of risks associated with investments.• Interest rate risk: This occurs due to changing interest rates. • Currency Risk: This applies to foreign investment. Here, the value of an investment changes due to changes in the value of the currency.There are other risks too that you may not know of. But all these risks are equally important. They impact the overall risk associated with the portfolio.• Reinvestment risk: This occurs when the investor has to reinvest his investments. For example, take your bank fixed deposits, which mature from time to time. You must reinvest these upon maturity. But at the time of reinvesting the amount, the interest rate might not remain the same. This is the Reinvestment Risk. Investors must consider this when opting for renewal of investments.• Credit risk: This can arise when you invest in securities or bonds. For instance, bonds with a credit rating of AAA are lesser risky than AA ones. Even though AA bonds might have a better yield, the inherent credit risk is a consideration.• Tax risk: This refers to the risk of unnecessarily paying a higher tax. Tax riskoccurs when you ignore the tax-saving provisions laid down by the Income Tax Act. So, when opting for investments, do consider the tax efficiency of the product. This will reduce your tax risk, especially at the time of maturity.• Inflation risk: The returns on your investment may be lower than the inflation rate. This is the inflation risk. So, while planning for investments, think of the future. Think of the purchasing power of money and how it changes.• Concentration risk: This risk comes when there is a lack of portfolio diversification. You can curtail this risk with a diverse portfolio. That is, your investments must include different asset classes, horizons, and products, etc.Conclusion: People’s horizon of investment defines their risk-taking capacity. Also, risk is associated with high returns. If losses are on one side of a coin, so are the returns. Hence, the risk-return trade-off is of extreme importance and so is the need to understand types of risk management for better investing. Avoiding risk can be equally risky. For example, an investor may avoid equity to reduce his/her market risk. But this increases the risk of not beating inflation or having a concentrated portfolio.So, weigh the various risks to reduce your over portfolio’s risk and employ risk management strategies in your portfolio. If you need support, turn to IndiaNivesh which specialises in this.What next?We spoke about how avoiding market risk can affect your ability to beat inflation. This is because risk has a close relation with your returns. Let’s look at the risk-return trade off next. Disclaimer: Investments in the securities market are subject to market risks. Read all the related documents carefully before investing.
Investing 2.0: Where to Invest Derivatives
Derivatives or financial derivatives, as the name suggests, are financial contracts that “derive” their value from an underlying asset. Simply put, derivatives help you make profits by taking a call on the future value of its underlying asset. There are many types of financial derivatives of many assets such as commodities, currency, indices and stocks. For the sake of simplicity however, we will delve into equity financial derivatives for better understanding. How does an equity derivative work?Suppose you buy a derivatives contract on stock A that is trading at Rs 2,000 in the spot market. The expiry date of the contract is a month later. At this time the stock trades at Rs 2,500 in the spot market, but you can still purchase it at Rs 2,000, thereby making a profit of Rs 500 per share. The same holds true if the stock price were to fall by Rs 500. In that case you would incur a loss of Rs 500 per share. What are derivatives used for? To know the uses of financial derivatives let’s look into the below terms:Hedging Derivatives offer you the opportunity to protect yourself against price fluctuations. You can use a derivative strategy to protect yourself against a price rise or a price fall. This is called hedging. Risk transferEvery investor in the market has a different risk appetite or tolerance to bear losses. Derivatives can be used effectively to transfer risks from risk-averse investors who want to protect themselves against price fluctuations to risk-tolerant investors such as speculators who take contrarian trade positions to enhance profits. Different types of derivatives contracts Futures and forwards:As explained earlier, future contracts are agreements coined to buy or sell a specified number of shares at a pre-stipulated time in the future. Forwards can be called a variant of futures but ones that can be customised to a certain extent. Unlike futures, these are non-standardised in nature and cannot be traded on the exchange. Options: Options are similar agreements like futures, but one in which you can exercise a choice or an option to meet the obligation. For example, if you have an option contract to buy 50 shares on the expiry date, you can choose whether or not you wish to do so. Options too can be traded on the stock exchange. What do you need to invest in derivatives? To understand how to trade derivatives here are the following factors you need to consider:A demat account- Just like trading in shares, a demat account is a pre-requisite for dealing in derivatives.Trading account- A trading account is linked to your demat account and serves as your unique identity in the market.Margin maintenance- Initial margin- When you decide to deal in derivatives, you need to deposit an initial margin, that is decided by the stock exchange. It is a risk containment measure on behalf of the exchange, and depends upon the total value of your outstanding position as well as the average volatility of the stock and interest cost over a stipulated time period. This margin is adjusted daily depending upon the market value of the open positions you hold. Exposure margin- This margin is also levied by the exchange and is used to control excessive speculation and volatility.Mark to market margin- Apart from the two margins mentioned above, you also need to maintain a Mark to Market (MTM) margin. This margin covers the difference between the cost and the closing price of the contract on a day to day basis.Derivatives trading must do’sResearch- This is the most important aspect of derivatives trading. Derivatives trading is far more complex than stock trading, so do not make a trade unless you are completely sure of the position you are taking, the purpose of the same and the possible consequences. Maintaining the margin amount- Margin maintenance plays a big role in derivatives trading. It is always prudent to maintain some extra amount in your account as the margin amount changes with the rise and fall in the underlying stocks. Disclaimer: Investments in the securities market are subject to market risks. Read all the related documents carefully before investing.
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