"Invest according to your risk appetite" is a refrain often seen in personal finance articles. This is as useless as it is meaningless.
The single most important ailment among investors is their inability to recognise appropriate benchmarks and objectives
- inflation as the primary benchmark for long-term goals
- capital preservation as the primary objective for short-term goals
- tax-efficiency is a secondary obective for both types of goals
Someone who understand the above, will immediately recognise that
- mixing investment and insurance is a terrible idea
- tax-planning is a tertiary objective
Notice that the risk associated with both type of goals is the same:
- the inability to meet a certain expense either in the next few years (short-term goal) or after a couple of decades (long-term goal)
For long-term goals this risk stems,
- from not having invested enough in productive assets like equity (inadequate exposure) or
- from not having invested enough in non-productive assets (inadequate investment)
For short-term goals this risk stems from investing a little too much in assets (like equity) which are too volatile to be productive within a few years.
Now that we have a broad framework, please tell me, 'What is your risk appetite?'
The ideal answer ought to be,
My risk appetite is irrelevant. All that matter is the risk proifile of the goal I am investing for.
As we all know, it is an ideal answer because when it comes to retail investors, extreme choices seem to be the norm.
We have people who like the comfort of a guaranteed income from their endowment policies for their long-term goals. They would celebrate when the insurers gives them a bonus - a thin slice of profits earned by investing policy holder premium in equity and bonds. Many of such investors are completely unmindful of the effects of inflation and if they are investing enough. All they want is a packaged product. This constitutes a vast maority of Indians.
Then are there others who like the 'guaranteed' profits from real estate, unmindful of liquidity issues involved.
Then we have a small group which loves to dabble in equity, unmindful of the importance of asset allocation.
In personal finance forums, one regularly comes across people who claim, I have 'high'/'medium'/'low' risk appetite!
What on Earth does that mean?
While I am investing as per the risk profile of my financial goals, I do not know what my risk appetite is.
My long-term goals have 60% of equity exposure and rest in debt. I invest in equity because it is necessary to do so.
I have been investing only from mid-2008 and I have not seen a major crash. While I have become more and more comfortable with the daily volatility associated with equity folio, I can only hope I will be able to emotionally stomach a large crash and think logically at that time.
Risk appetite can fluctuate too. All I can do is to hope that I can 'keep calm and use my head' (a line from the movie Tombstone), when the chips are down.
My point is, the DIY investor must learn to ignore their risk appetites and think logically and act as per the need of thier financial goals. It is not easy, but one will have to try.
The main reason for this is, risk appetites are not easy to determine. When the market is down, most people are not hungry. The same people will feel famished when the market heads north.
It is impossible to determine appetites with a set of questions like (source: HDFClife insurance)
- Which of the following portfolios describe your portfolio most accurately ?: Investment risk is high/medium/marginal/low
- You can see the rest here (be sure to read the disclaimer which washes off any responsibility!)
Knowledge of risk appetites are necessary for those in financial advisory but they too use risk profiling tools with similar questions. I am sure they would agree that gauging a clients risk appetite will take several years and that a set of questions cannot do the job. They will have to do their best to make clients act as per the risk profile of their financial goals and not as per their risk appetites.
Let us ignore dumb statements like 'invest as per your risk appeite or risk-taking ability' and act logically.
We have a life-time to gauge our own risk appetites and answer the titular question. As long as the answer does not determine our fiscal healh, we should be fine.
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