Last Updated on August 29, 2020 at 12:14 pm
“My goal is long-term. If my risk appetite is moderate, what kind of mutual funds should I choose?”. This is a common question asked in personal finance forums. We discuss what investors in this situation should do.
Member of FB group Asan Ideas for Wealth would have encountered these type of questions dozens of times in the last few years. Unfortunately, ask an innocuous counter-question, “what does moderate risk appetite mean?” and the person is confused, even insulted, but has no meaningful answer.
The reason being, we cannot define in any meaningful way what risk appetite is let alone categorize it as low, medium and high. There are expensive tools out there making a fortune by selling questionnaires to financial planners. An honest, experienced financial advisor would tell you at least two facts about assessing investor risk.
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One, it is like asking a person with no preparation or experience what percentage of a marathon is he likely to complete. Two, how an investor reacts to huge gains or huge losses can be known only after the event occurs.
Offering suggestions to an investor who says, “I am scared of equity” is relatively easier compared to self-proclamations of moderate and high-risk appetites. See: for example: How to invest without using mutual funds
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 what the risk necessary for my financial goals. This is however good enough to manage a portfolio.
Advisors should focus on assessing a person’s risk quotient (RQ) and not, risk appetite. Even an ignorant investor can have a high-risk appetite (some would argue it is high because of ignorance). Of course, to do this, advisors themselves should have a respectable RQ and people who worry about such practical difficulties are better off DIYing!
What does RQ mean? Ask yourself or any of your friends invested in equity (stocks or MF): What return do you expect from your investments over the next 15 years. If the answer is just a number like 12% or 10% then their RQ is insufficient to be successful in equity.
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 simply 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 also 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 clients can be taken on. If a self-assessment is being made, type 1 investors should not be in a hurry to invest.
What mutual funds should I choose if my risk appetite is moderate?
If you expected to see a list of mutual funds and got irritated by the above discussion, then excuse me for taking a dim view of your RQ. The simple truth is, if you cannot know your risk appetite, there is no way for me to know it. So only the usual yadda-yadda like, “have adequate equity exposure for long-term goals” can be coughed up.
Index funds or aggressive hybrid funds or balanced advantage funds or dynamic asset allocation funds – all categories would fall to different extents if the market falls. If the Nifty fell by 30% and your fund fell 20%, I have no idea how you would react to it when actual money is invested.
Emotionally 20% is not 10% less. Some could say, I expected it to not fall at all or fall much less. This is why risk appetite assessment is so tricky. The situation is similar to marks vs intelligence.
If I conduct an exam for my students, I can only gauge how they have systematically satisfied the requirements of the system. I have no idea how intelligent they are. No one knows and no one needs to know.
To graduate a student should appreciate the needs of the system and fall inline (no system is without fault but hey it is a choice!). Similarly investors should appreciate their future needs and seek appropriate solutions for those needs and 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 start increasing 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 markets monthly return is negative. Forcer yourself to invest regularly without worrying about the current condition of the market. Limit equity exposure to no more than 50% to 60%. Once you hit this mark start thinking about how you are going to 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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