Investing for a purpose is a two-step process. The first step requires identifying the objective, say, buying a house. The second step involves buying investment products to achieve the objective. Sometimes, you may have less time or less capital to reach your objective. In such instances, you may be required to buy risky investments to earn higher returns. The question is: Will you take marginally more risk on all your investments or will you take lot more risk on some of your investments? In this article, we apply investment psychology to explain your investment decision.

Mental buckets

You are most likely to be both risk-averse and risk-seeking at the same time! That is, you will buy insurance policies and will just as well buy lottery tickets. Why would you behave this way? The answer lies in your desire to avoid losses and yet aspire for a better lifestyle. You use current income to build your investment portfolio. But what if the current income stops due to death or disability? You, therefore, buy insurance policy to protect your family's basic standard of living during such difficult times.

You also aspire to have a higher standard of living. But achieving such living standards requires you to take higher risks. You will prefer to take such risk once your basic standard of living (we call this the protective assets in our wealth mapping process) is protected. Lottery is one means of achieving the required lifestyle!

This tendency to buy insurance and risky assets is deeply rooted in what behavioural economists call as mental accounting. It refers to your behaviour to “mentally” create accounts and treat decisions as separate from each other. For instance, you may create separate accounts for protective assets (insurance) and aspiration assets (lottery). Likewise, for investments, you may consider income returns as different from capital appreciation. We will use mental accounting to address your risk choices.

Core and explore

Your typical choice of investments will be fixed deposits, mutual funds and direct exposure to equity and commodity. A conservative choice among fixed deposits would be to invest in public sector banks. A risky alternative would be to invest in corporate fixed deposits to earn higher interest rate.

Similarly, a conservative equity investment would be large-cap index funds or broad-cap index funds (such as based on the S&P CNX 500 Index). A risky alternative would be to invest in active funds, sector funds and mid-cap funds.

The question is: Should you buy risky investments such as AAA-rated fixed deposits and active funds? Or should you invest in conservative investments such as index funds and bank deposits and take higher risk by investing in commodity futures and sector funds?

Given that you may practice mental accounting, taking more risk on some of our investments may be appropriate. So, how should you create such a portfolio? We suggest that you set-up an SIP on index funds, recurring bank deposit and, perhaps, a fixed monthly investment in PPF. We will call these investments conservative core portfolio. You should then set-up SIP on mid-cap funds, sector funds and also dabble in commodity futures, if required.

This would be your “explore” portfolio. In short, you are creating a core-and-explore portfolio, where core is conservative and explore, more risky.

Conclusion

You typically buy one investment at a time, and incidentally create a portfolio. That is, you do not consider how your existing portfolio's risk is affected if you add, say, a mid-cap fund to it. Besides, you are both risk-seeking and risk-averse. Because you typically practice mental accounting, it is optimal for you to create a portfolio that has large exposure to “safe” assets and some investments in more risky assets.

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