Least-effort portfolio: Why assess your risk appetite?

We want you to read this article with an open mind! Why? You know how important it is to assess your risk appetite to create an investment portfolio.

We are suggesting that you do not have to measure your risk appetite because you cannot meaningfully do so! If it offers you any comfort, even investment professionals are yet to find a fail-safe model to assess an individual’s risk appetite.

In this article, we discuss why you can side-step the issue of measuring your risk appetite. Remember, this argument applies only if you manage your own investments.

Risk psychology

Your risk appetite is a function of your ability to take risk and your willingness to take risk. The latter is a psychological factor and is, hence, difficult to measure. Why?

You will be typically fearful of equity investments after a market crash and you will underestimate the risk in equity investments when you observe prices moving up sharply. Measuring your risk appetite could, therefore, be incorrect; for your fear, or the lack of it, driven by the market conditions will influence your risk assessment.

Then, there is another issue. Your brain is not well-geared to simulate fear. And why is this important? Remember, risk is the possibility of loss occurring in the future. So, risk assessment is about simulating today how much loss you can withstand in the future. Typically, your risk tolerance will be higher than your loss tolerance. And the reason is simple: simulated-pain will be much less painful than the actual pain! It is moot if your assessment of your risk tolerance today will be helpful when you actually face losses in the future.

Of course, your ability to withstand losses in the future may be higher than it is today; for your income and net worth can increase as you progress in your career. It is, however, difficult to forecast changes in these wealth-related variables.

Objective reason

Your risk appetite is useful in deciding how much you should invest in equity and bonds. But from the above discussion, it is clear that this proportion can change because your willingness to take risk can change. We now extend our discussion further. You create an investment portfolio for a purpose. So, your task is clearly laid-out: you should save as much as possible, and invest in assets that can help you achieve the stated objective.

Now, based on your savings rate and your goal, what if you are required to invest 70 per cent in equity? You have two choices- either invest 70 per cent in equity and accept the associated risks. Or reduce the proportion of equity investments, but suffer the possibility of not achieving your objective. You should swallow your fear and invest 70 per cent in equity, if your goal is, indeed, important.

In other words, why be too concerned with your risk appetite if your objective is to achieve a goal, and if that objective requires you to take a certain proportion of equity investments? We are not underplaying the importance of risk assessment. We are simply wondering whether you should spend your time and effort trying to measure your risk appetite, when doing so is not to so easy. So, what should you do?

Conclusion

You should start with >63 per cent equity allocation and modify the proportion annually to rebalance your portfolio and manage shortfall in investment returns.

Remember this: your equity allocation should decline with age during your working years, so that you have not more than 25 per cent in such investments when you retire. You can, perhaps, fine-tune this investment process by assessing your risk appetite, but that comes at a cost- your time, effort and a not-so-accurate model. Should you?

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. Feedback may be sent to knowledge@thehindu.co.in)

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