‘How much risk an investor can take’ and ‘how much risk he should take’ are two very different things. ‘Invest as per your risk appetite’ is half-decent advice. However it is not universally valid. A person who hates equity can choose to avoid it only if he can afford to regularly invest a sizable (often impractical) amount of money for long term goals. A person who loves equity cannot invest in it if his goal is only a couple of years away. The investors risk appetite is relevant only when the goals risk appetite is also accounted for.
The goals risk appetite determines the risk the investor should take while the investor risk appetite determines the risk the investor can take. A goals risk appetite can simply be represented by estimating the return needed with the following inputs
- How much the investor can invest
- How long the investor has for the investment to grow
- A reasonably close estimate of how much is needed.
Some background is necessary to put this post in perspective. This post is the 4th in a series on long term goal-based investing:
- Part I listed in detail the steps needed for goal-based investing and included a calculator to determine the return needed for one goal.
- Part II dealt with the importance of rebalancing when accumulating a corpus. It came with a rebalancing simulator with historical Sensex and FD returns to drive home the point.
- Part III dealt with consolidating and optimizing all financial goals. A way to minimize the total amount required for investing by treating all goals to be funded from a single portfolio was described with a calculator.
- Part IV, which is the current post, also deals with consolidation and optimization of all financial goals. Here too we shall assume all goals to be funded from a single portfolio and determine the return required to accomplish all goals with the total amount we can spare each month as the input.
The idea of a single portfolio is briefly explained here. More details can be found in part III. The amount we can afford to invest for all our financial goals (excluding PF or NPS contribution) is assumed to be invested each month from now until retirement. As the corpus grows we take out what we want from it as and when required for all goals except retirement. When we are ready to retire, the final value of the corpus is (ideally) equal to the retirement corpus needed for a financially independent retirement. The idea then is to determine the return required. From this, given the debt allocation and estimated (conservative) post-tax debt return, the equity return required is estimated.
When return is determined:
- The amount we can invest is an input. That is, the amount we must invest (optimized or not) is not involved. Since, at any point of time, we can only invest what we can, the input is by default optimal!
- The return needed is an output. That is, the return expected is not involved
The advantage of doing this is, it can immediately warn the (wary!) investor if something is impractical with the goal inputs. If the returned expected is too low it could mean inflation expected is too low and/or current cost of goal input is too low.
If the return is too high (the more common problem!) then it could mean that for the amount we can invest each month, some goals (or at least parts of them) cannot be achieved in tune with expectations. So we may need to modify goal inputs accordingly.
The goals in question are long term goals. That is they are 10 or more years away. This implies that we could afford to invest 60-70% in equity and the rest in debt. Assuming a post-tax return of about 6% from debt instrument the returns from equity can be estimated. If the return expected from equity is more than 12%, I would get worried and revisit my goal inputs. Although the worry-threshold may vary from person to person, equity returns above 15% even for goals more than 15 years away is simply impractical.
So decision making in this case is a combination of the investors and the goals risk appetite. That is the upper and lower limits of ‘how much risk I can take (and therefore returns I can expect*)’ is determined by ‘how much risk I must take’.
Use the attached calculator to check if your long term financial goals are achievable, given the amount you can invest.
- Inspiration for this calculator: Video demonstration of FiscAlmanac, a comprehensive, but expensive, financial planning software.
- The ideas mentioned in this post and part III were first introduced to me by Mr Centhil of Horus Financials. An elaborate example can be found here: The Fallacy of Goal based Investment ‘Tagging’
- Quote adapted(*): Risk and return are not necessarily related; risk and expected return are related. If there were no risk there would not be higher expected returns. - Larry E. Swedroe in " Think, Act and Invest Like, Warren Buffet"