Common sense about risk

Risk versus returns. Nothing ventured, nothing gained. The idea that the more returns you want, the more risk you must take is ingrained deeply into the way we think about investing. This is not just a concept or general rule of thumb anymore. There’s even a Nobel Prize that has been given out for work from which this risk-return concept can be mathematically derived.


Before someone gives you any investment advice, they are supposed to figure out your ‘risk tolerance’. In fact, in India as well as in most well-regulated parts of the world, this is a mandatory part of being a registered financial advisor. However, there is something fundamentally unsound about this idea. Not the idea of judging an investor’s risk tolerance, but the concept of a person having a single tolerable risk level. In reality, the same person almost always has different risk tolerances for different aspects of their financial life.


Conventionally, financial advisors treat all of an investor’s investments as a single portfolio and try and tune this to the investor’s self-perceived risk-tolerance. They try to fathom this risk-tolerance by asking some questions and/or by rules of thumb based on age, income stability and some other factors.


I have never believed that such an approach is useful. It may elicit something about an investor’s attitudes but it can’t be the basis for planning an investment portfolio. That’s because each saver, each family, has many different financial goals and each needs a separate portfolio. Think about it. A financial goal is defined by a particular purpose that the money will be used for, as well as a time-frame. Example goals could be ‘Child’s Higher Education’ which might be needed in eight years, or ‘House Purchase’ in about five years, or a ‘Holiday to Europe’ in about three to four years.


Some goals have a precise time-frame (like a child’s college education) while others, like an expensive holiday, would be nice to have but not crucial, so to speak. Again, some things can’t be postponed but others can be. There are also general goals like having enough emergency money on standby but that doesn’t need much of an investment strategy. As you’ll realise when you think about these examples, each goal has a different risk level. Moreover, this risk level itself varies not just with the nature of the goal but with how far into the future the targeted goal fulfilment is.


Therefore, the approach to portfolio-making that I have evolved at Value Research is based largely on the time-frame for which you are investing. For investments whose goals are far away, we can take more risks and get higher returns. The nearer a goal date is, the less risk you can take. For money that might be needed immediately, zero risk tolerance is needed. This approach means that the conventional idea of a person’s risk tolerance is meaningless.


One important implication of this approach is that eventually, the long-term becomes short-term and then becomes imminent. Your eight-year old daughter will start her higher education in 2032 and that’s a long-term goal. But by the time 2027 arrives, it’ll be a medium term goal and in 2031 it’ll be a short-term goal. Therefore, the way these investments are treated must change with time. The risk tolerance that the same goal needs keeps getting lower and lower as D-day approaches and thus the portfolio earmarked for fulfilling that goal must also change. None of these real-life nuances are captured in the conventional way of rating risk-tolerance.


At the end of the day, no conventional set of investment products and services will take all this into account. Savers have to learn the concept themselves and take care of their needs. However, as you can see, it’s all just simple common-sense – something that is not available as a service but which you yourself can provide.


Source: Valuesearchonline

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