PORTFOLIO IDEAS. Be driven by desire, not risk

Your investment portfolio is not strictly a product of your risk appetite. By this, we mean how much equity and bonds you have in your portfolio is not really a function of how much risk you can take. In this article, we show why your portfolio should be instead created based on your desire to achieve a life goal.

If you have to shed 10 kilos to run a marathon, would you? The answer, of course, depends on how important running the marathon is for you. If you have a strong desire to run the marathon, you will do whatever it takes to shed 10 kilos. Why should building an investment portfolio to achieve a life goal be any different?

In a classical investment world, you are expected to create a portfolio based on your ability and your willingness to take risk. This approach starts with your risk appetite and then decides on how much you should save each month to achieve your life goal. Reality is, of course, different. Your ability to save each month is driven by your current income, current consumption and desire to meet multiple life goals.

So, instead of fixing the risk appetite to determine the savings amount for each life goal, reality forces you to fix the savings amount for each goal and settle for the resultant risk. In this world, what if you come from a household where investing in equity is unthinkable? Will you give up your dreams when you realise that investing only in bonds will not help you accumulate the desired wealth to achieve your life goal?

So, we suggest that you focus on your life goals and not on your risk appetite. The stronger your desire to achieve a goal, the more flexible you should be when it comes to designing your portfolio. And if that means you have to invest in equity and bonds, you should overcome your fears and invest in equity! Why? You know that the expected return on equity is higher than that on bonds. So, if achieving a life goal is based on your portfolio earning a return higher than that on bonds, you have to necessarily invest in equity.

So, how much equity should you have in your portfolio? That depends on several factors. Suppose you want to accumulate ₹40 lakh in seven years to make down payment for a house. Assume you can save only ₹32,500 every month towards this life goal. Your portfolio has to earn 10.5 per cent compounded annual return to accumulate ₹40 lakh in seven years. Next, you need the expected return on equity and bonds. You could assume that equity offers 12 per cent post-tax returns, and bonds 5 per cent. Now, find out what combination of equity and bonds in your portfolio can help you earn 10.5 per cent compounded annual return. In this case, you have to invest 70 per cent in equity and 30 per cent in bonds. That is your asset allocation.

You may be uncomfortable with this asset allocation. If this is a high-priority goal, you should decrease your equity allocation to reduce the risk of failing to achieve the required wealth at the end of the time horizon. This means you have to increase your monthly savings. Or reduce your desired terminal wealth. If the goal is to buy a house, you may have to settle for a smaller house! You can also increase the time horizon if your goal can be postponed.

But you cannot always increase the time horizon or save more. In such cases, you must invest the necessary proportion in equity to achieve your life goal. Your unwillingness to take risk due to psychological reasons should not deter you from achieving your dreams!

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in