How do I find my risk-taking capacity and choose an asset allocation

Published: August 4, 2023 at 6:00 am

We received this interesting question.”First of all, I’d like to thank you for the blogs and videos that you make. I’m fresh out of college(21 years old) and will start my first job soon. Your content has spiked my interest in personal finance and made me examine it analytically”.

“My question is rather simple but is something that I can’t figure out EXACTLY. How do I figure out how much per cent I can invest in equity and debt? My main goal is retirement by the time I’m 45-50”.

“I have met friends, colleagues and relatives with various views on asset allocation. Ranging from 30% equity exposure all the way up to 85% equity exposure. From your videos, I learned that a good equity exposure could be around 50-70% for a span of 20+ years”.

“How do I determine my risk-taking capability and drill down on an exact number? PS: I am not expecting a numeric answer but rather a method that someone like me can use to figure this out independently”.

It is fantastic to see a 21-year-old worry about asset allocation when most investors more than twice your age don’t care about it. “How much equity should I invest in for a long term goal?”  is a tricky question.

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On one corner is a technical answer: Using reasonable return expectations for equity and debt (after tax!) and considering the inflation for my goal, I can arrive at an approximate overall portfolio return (after tax).

I adjust this allocation and return expectation considering the amount I can invest for my goal, ensuring the return expectations are still reasonable. The steps are explained here: Deciding on asset allocation for a financial goal.

Also, try the freefincal Asset Allocation Calculator on the SEBI investor website developed by M. Pattabiraman. These are among the nine freefincal calculators hosted there.

Now, that is the technical answer to what should be my asset allocation and, more importantly, how much risk I need to take to achieve my long-term financial goal.

Once this is in place, we can address the emotional question, how much risk can I take (or emotionally handle)?

At 21, you have the biggest resource on your side – time. So I urge you not to worry too much about your equity allocation and consider the following:

  • Be emotional about your financial future. Tell yourself the key is achieving financial independence as soon as possible to have options available.
  • Choose an equal mix of equity and fixed income (debt). It will work just fine. Take my word for it, or you can see the data: Will Benjamin Graham’s 50% Stocks and 50% Bonds strategy work for India?
  • As you age, you will only grow confident about holding 50% equity – ensure it does not turn to overconfidence. Never forget equity is like fire. Fire is indispensable, but getting too comfortable with it can burn us.

You cannot determine your risk-taking ability by reading or viewing content or taking a quiz to “determine your risk appetite”. Learning about risks takes time, so start with something and learn on the fly. However, create a plan before you start so that you have a path to start with. You can always course-correct down the line.

At 21, the answer is simple. Older investors who have not taken enough risk before should compensate by increasing their investments as much as possible and modifying their financial goal expectations. They should gradually increase equity allocation depending on their age and emotional tolerance. Counsel from a SEBI registered fee-only advisor will help immensely (link points to our curated list of advisors).

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Pattabiraman editor freefincalDr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.
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