Risk perception decides the choice of one’s investment products. For instance, you may be averse to investing in equity funds because you watched your parents lose a fortune in the stock market.
Similarly, for some objectives or goals, your investments in bank fixed deposits could be riskier than your equity investments! In this article, we discuss how investment risk — a function of your objectives — should be viewed.
Goal-based investmentsRisk is typically understood as the possibility of loss in the future. However, risk takes a different meaning when viewed in the context of achieving life goals. Suppose you want to accumulate ₹50 lakh to meet a life goal 10 years hence.
Further, suppose you can invest about ₹20,000 every month for the next 10 years to meet this goal. This means that your investment account has to earn 14 per cent compounded annual return to accumulate ₹50 lakh, 10 years hence. So, the return you earn in the first year has to be reinvested along with the total capital to earn 14 per cent in the second year and so on.
The investment risk here is not the possibility of losing the capital. But the actual risk is the investment earning a return lower than 14 per cent in any year! Why? One will fail to accumulate ₹50 lakh in 10 years if the investment returns less than 14 per cent in any year.
So, for goal-based investments, the actual risk is that of your portfolio earning a lower-than-required return. This required return is called the minimum acceptable return (MAR). In a core satellite framework, your goal-based investments form part of the core portfolio. So, the risk on your core portfolio is tied to your MAR. Viewed in this context, investments only in bank fixed deposits will lead to failure of your life goals if your after-tax MAR is higher than after-tax interest rate on deposits.
The argument is different for your satellite portfolio which is not created to achieve any life goal. Rather it is meant to generate gains from short-term market movements. So, the risk in satellite portfolio is the possibility of losing your capital.
Risk is good!Risk is good if you assume it for a reason! In most cases, you invest in risky assets because the MAR for a life goal is higher than the interest rate on bank deposits.
Sometimes, the compelling urge to earn higher return may drive you to take higher risk. You should control such urges and importantly confine such investments only to your satellite portfolio.
You should also pay attention to how psychology drives your understanding of investment risk. For some, the perception of risk is a function of price visibility; more frequently you monitor prices, higher the perceived risk.
That is why most perceive real estate to be less risky than equity. For others, risk is perceived to be low if you have an illusion that you control asset returns.
This is one reason why many individuals prefer to invest directly in equity instead of buying equity funds.
Further, risk is also a function of your social environment like many consider gold to be a safe asset. You should moderate such risk biases if you want to achieve your life goals.
Why? In most cases, based on your MAR, you have to create a core portfolio containing both equity and bank deposits. And not doing so could be risky!
The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in