Portfolio Ideas. Risk is finally a question of perception

Do you feel that equity is more risky than real- estate investments? Or that gold is a safe asset? Why is that you are willing to invest in farmland or chit funds and not buy shares of listed companies? In this article, we explore these questions using behavioural psychology. Specifically, we look at why your fondness for real estate and gold and dislike for equity is not driven by the actual risk of these investments but by the risk you perceive!

Take chit funds, farmland and similar investments. These investments have typically not offered returns commensurate with the associated risk. Yet, you may choose to invest in such schemes. Why? One reason is herding. In some ways, we are like the zebras that crowd together when they spot a predator. That is, you and I find comfort in a crowd.

You choose a restaurant based on how many patrons are inside; more the number, better the restaurant ought to be! Your choice of investments is driven by similar logic. You perceive farmland to be less risky than it actually is for two reasons. For one, you draw comfort from the fact that your friends are also invested in the same asset. For another, lack of visible prices makes you feel that farmland investment is less risky than equity.

But why is that you perceive gold and traditional real estate to be less risky than equity? You have seen your family and friends accumulate wealth investing in land and houses.

Importantly, you have not witnessed real-estate prices crash like the stock market. So, you do not fear investing in real estate. In other words, if a crash has not happened in the past, you think it is unlikely or less likely to happen in the future. We call this phenomenon as the Black Swan Error.

You cannot conclude that all swans are white just because all swans you have seen so far are white! You have to spot just one black swan (which you can in Australia) to realise the fallacy of your argument. Using the same logic, just because a crash has not happened in the past does not mean it cannot happen in the future. Your black swan error makes you think that real-estate is significantly less risky than equity.

There is another factor. Being physical assets, real estate and gold act as both consumption and investment asset. So, whenever gold prices decline, you consider them as consumption asset meant for personal use as jewellery or to be gifted to your children. So, price declines do not hurt you. But whenever prices move up, gold becomes an investment asset that can be sold for profit!

If you perceive real estate and gold to be less risky than equity, you will most likely choose these two assets and invest less in equity. Likewise, you may invest in farmland and such alternative assets because you perceive such investments to be less risky.

Such behaviour can jeopardise your life goals. Why? Real estate is lumpy and illiquid and cannot be sold quickly. The risk-adjusted return on gold does not typically compare well with equity. That is why your goal-based portfolios should preferably contain equity and cumulative bank deposits. Equity can give you higher return, but with uncertain cash flow. Cumulative deposits balance this uncertainty offering pre-defined cash flows on maturity without the reinvestment risk.

To overcome your fear relating to equity investments, set up systematic investment plans on equity mutual funds. The auto debits from your bank account to the mutual funds in the subsequent months will enable you to distance yourself from the investments. This will help sidestep your perceived risk about equities and still invest in them!

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