How to moderate your risk behaviour

Create a portfolio with bond investments forming the floor and risky assets the upside

Are you taking more investment risk than necessary? Is your spouse taking more risk than you are comfortable with? If yes, then there is cause for concern. What if your risk translates into loss?

You could have an investment value-gap in your portfolio. In this article, we discuss some factors that arguably drive your or your spouse’s risk-taking behaviour. We then offer a solution to moderate such risk behaviour.

Risk tolerance

Your risk tolerance is a function of two factors: the ability and the willingness to take risk. Your ability to take risk is a function of your wealth and income level. Your willingness to take risk is, however, psychological.

You may come from a family that accumulated wealth by investing in risky ventures. So, borrowing money to invest in equity may be normal for you!

Call it epigenetics, if you will, but the external environment shapes your risk-taking behaviour. Your genetic code also determines whether you are risk-averse or otherwise! Suffice it to know that the genes that regulate your dopamine and serotonin determine your risk-taking behaviour.

This includes performing dare-devil acts such as tightrope walking across a tall building or taking unnecessary investment risks.

But what is unnecessary investment risk? Suppose you need 4.5 per cent post-tax returns on your investments over 10 years to buy a beach house. You ought to invest in a cumulative bank deposit earning post-tax returns of at least 4.5 per cent to achieve your goal.

Your risk genes, however, can prompt you to take more risk, such as investing in equity or commodities. You may rationalise that aiming for higher returns is, indeed, rewarding!

Another reason why you could be taking more risk is because of the Peltzman effect. Peltzman noticed that some car drivers became reckless when the safety belt was made mandatory. His argument is based on risk compensation. Now, safety belt reduces the risk of driving-related injury. So, you arguably compensate for the risk by driving faster. In the process, you could harm yourself, the pedestrians and the cyclists on the road.

Now, extend this argument to investments. Suppose you are confident of bridging any shortfall in your portfolio at the end of the time horizon for your life goal (referred to as the investment value-gap). This may be because your siblings have offered to help or you are sure of receiving a large inheritance. This safety net could prompt you to take more risk on your investments.

Needless to say, such risk-taking behaviour can harm your chances of achieving your goals.

Floor-upside rule

You should create your portfolio using the floor-upside approach. Your bond investments act as the floor, while risky assets form the upside. Suppose you need ₹4 crore in eight years to buy your dream beach house. Further, suppose, you need a minimum of ₹2.8 crore to buy a smaller beach house. Then, you should invest in a bank recurring deposit to accumulate at least ₹2.8 crore in eight years. You can invest the rest of your savings in equity or other risky assets. This way, your risk behaviour will not entirely jeopardise your life goal.

There are two ways to implement this plan. You could either request your spouse or hire an investment adviser to act on your plan.

If you are unmarried, seek your best friend’s help. You should not implement your own plan because you will struggle to control your risk attitude. Note that your siblings or parents could have similar risk attitude if your risk-taking behaviour is genetic.

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in

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