Last Updated on December 17, 2023 at 6:40 am
“I have a long-term investment goal and a moderate risk appetite. Which mutual funds should I select?” This is a query often seen on personal finance forums. We delve into what actions should be taken by investors in such scenarios. However, when asked the seemingly simple follow-up question, “What does a moderate risk appetite entail?” the inquirer is often left puzzled and even offended, with no apparent response.
This is because the concept of ‘risk appetite’ cannot be definitively defined, let alone divided into low, moderate, or high categories. Various costly tools exist, making a profit by selling surveys to financial advisors. Nevertheless, a frank and seasoned financial consultant would likely tell you two things about evaluating an investor’s risk.
First, it’s akin to asking an untrained individual how much of a marathon they could likely finish. Second, one can only understand how an investor will respond to substantial profits or losses after the event.
Offering suggestions to an investor who says, “I am scared of equity”, is relatively easier than self-proclamations of moderate and high-risk appetites. See: for example: How to invest without using mutual funds.
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Investors should not be making assumptions about their risk appetite. I only saw my first equity crash after 12 years, and in hindsight, though it seemed steep, the quick recovery has diminished the pride associated with the experience.
My risk appetite has not yet been severely tested. I have no idea how I would react at that time. I have no idea what my risk appetite is. I have no idea what my risk tolerance is. All I know is the risk necessary for my financial goals. This is, however, good enough to manage a portfolio.
Advisors should prioritize evaluating an individual’s risk quotient (RQ) rather than their appetite for risk. Even an uninformed investor may be willing to take high risks, sometimes due to a lack of knowledge. To effectively assess RQ, advisors must possess a commendable RQ themselves. If the practicality of this seems daunting, then it’s wiser for such individuals to manage their investments themselves.
Confused about RQ? Try this: Ask yourself or anyone you know who has invested in equities, like stocks or mutual funds, what returns they anticipate from their investment over the coming 15 years. If the response is a mere percentage, like 12% or 10%, then it indicates their risk quotient is not developed enough to thrive in the equity market.
Why? The spread in max and minimum returns possible from equity over any period – 5 or 15 years – is so large that no one can sit and expect a return. See: Do not expect returns from mutual fund SIPs! Do this instead!
Fact: Returns from equity are uncertain no matter what you do. So a combination of low expectations, suitable investments and systematic portfolio management is necessary and reasonably sufficient to create enough wealth for our future needs.
Judging the proximity of the client’s response to the fact, RQ can be assessed by advisors as, say,
- inadequate to start investing or even provide advice
- amenable to suggestions
- superior = easy to work with (advisor may not be necessary)
Type 1 clients can be directed to simple literature on the “basics”, and types 2 and 3 can be taken on. If a self-assessment is being made, type 1 investors should not be in a hurry to invest.
Apologies if the above discussion wasn’t what you expected, particularly if you were hoping for a list of mutual funds. It’s important to understand that making such recommendations is challenging without understanding your risk tolerance. I can only provide general advice, such as the importance of sufficient equity exposure for long-term objectives.
Regardless of the type of fund you choose – index, aggressive hybrid, balanced advantage, or dynamic asset allocation – they will all experience varying degrees of fall if the market does. For instance, if the Nifty falls by 30% and your fund falls by 20%, I cannot predict your reaction to this decrease, especially when there’s real money at stake.
The impact of a 20% decrease is not simply 10% less than a 30% decrease. Some might have expected their funds to remain stable or decrease less significantly. That’s what makes assessing risk appetite so complex. It’s akin to the relationship between test scores and intelligence.
As a teacher, I can administer a test to measure how well my students meet academic standards, but this doesn’t provide insight into their level of intelligence. Their intelligence cannot be easily measured, nor is it necessary to do so.
To graduate, a student should appreciate the system’s needs and fall in line (no system is without fault, but hey, it is a choice!). Similarly, investors should appreciate their future needs and seek appropriate solutions. They should not get carried away by untested, unsubstantiated opinions of how much loss (or gain) they can stomach.
So what should investors do? Assuming this is for a long-term goal (say 25 years), gradually increase your equity exposure with an index fund. Start with, say, 5%-10% of your monthly investment. Gradually increase it over the next few years. All the time, observe and record how much the fund value fluctuates. Get used to the volatility.
Force yourself to invest a little extra if the market’s monthly return is negative. Force yourself to invest regularly without worrying about the market’s current condition. Limit equity exposure to no more than 50% to 60%. Once you hit this mark, start thinking about how you will manage this risk, in particular, gradually reduce this equity exposure. In the meantime, as per market movements, your ability to handle risk will be tested in real time with real money. There is no other way.
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Dr 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 14 years of experience publishing news analysis, research and financial product development.
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