Investors have different levels of risk tolerance. Some don’t bat an eyelid even if their portfolio nosedives by 25-30% while others worry even if their portfolio is down half a percent.
The first category of investors are likely experienced investors while the second category have a low level of risk tolerance. How should such investors with low risk appetite or tolerance invest their money? Is it a must for them to take exposure to equity or equity funds? Here, I want to contrast between risk taking ability and risk tolerance.
Risk taking ability depends on age, net worth, cashflows, financial goals, family situation etc. A and B need Rs 1crore for retirement. At the time of retirement, A has net worth of Rs 1 crore while B has net worth of Rs 10 crores. Risk taking ability for B is clearly higher than A. Even if B loses some money, he still has money for a comfortable retirement. No such luxury for A.
Risk tolerance is more about your behaviour if the markets move adversely. By the way, investors with low risk tolerance need not be risk averse in general. It is not that they do not make risky investments or do not take risky decisions. Just that they struggle to cope with volatility in equity prices. Let’s consider a few examples.
Real estate prices are volatile too. However, since we do not see market value of property change every minute, we are fine holding real estate for long term. More importantly, there is a conviction that real estate prices always go up (which may not be correct). Whatever the reason, it helps you hold on to your real estate (a volatile asset) for long term and ignore volatility.
Because of my profession, I interact with many entrepreneurs and professionals (non-salaried). Even though they are game with the risk associated with their work (and have chosen riskier career paths), not all of them are comfortable when it comes to volatility with investments. Surprising, isn’t it? Perhaps, they want to be in control. Had something gone wrong with their business, they at least could have done something about it. With market investments, firstly, it is not easy to figure out what went wrong. After all, it was the same a few days, weeks or months back. Even if you do, there is little you can do about it. Someone else runs that business and stock markets can be irrational. By the way, this is just my guess.
It could be about perception too. Possible that they do not consider real estate investments or their businesses risky.
Whatever the reasons are, we still get to figure out what such investors with low-risk tolerance for equity investments can do. Here are a few ideas.
If you cannot digest market volatility, you don’t have to invest in equity markets.
While you may have to forgo greater return potential that equity markets offer, avoiding equities altogether is a million times better than (buying high and) selling equities at market lows due to fear. You are unlikely to make any money by buying high and selling low.
Moreover, it is not that you cannot achieve your goals if you don’t invest in equities. Parents of many of us never invested in equities. Are they not leading a comfortable retirement? I am sure many of them are. If they are not, not investing in equities is unlikely to be a reason.
Let’s say you want to accumulate Rs 1 crore for retirement in 20 years.
#1 You invest in a multi-asset portfolio (let’s say just equity and debt) and expect to earn 10% post-tax on your investments. You need to invest about Rs 14,000 per month and you live with volatility.
By the way, I may be wrong in depicting volatility to be something benign. At the same time, short term volatility is a lesser problem to a patient investor who is in accumulation phase. For such an investor, the losses are only notional. To an investor who is withdrawing from the portfolio, market volatility translates to real risk of missing out on your goals (not having enough money or running out of money too early).
#2 You shun all volatility and simply invest in EPF, PPF and bank fixed deposits. You earn 7% p.a. on your investments. In this case, you will have to invest about Rs 20,000 per month to reach your target in 20 years. So, you need to invest Rs 6,000 more and you are good. You don’t have to worry about volatility.
Therefore, if you check your equity portfolio 5 times a day or you lose sleep when your equity investments go down, there is little point in investing in stocks or mutual fund investments. Stay away.
You invest only that portion of your assets into equity market that you don’t worry about. It could be 10% or 20% or whatever you are comfortable with. Many of us think about lotteries in such a way albeit with much lesser amounts.
The right percentage for you is one that you wouldn’t worry about checking the value of equity investments for a couple of years. Or even if you do, you wouldn’t have second thoughts about your allocation. You can rebalance your portfolio at regular intervals to keep equity allocation within your comfort zone.
You divide your investments into buckets.Let’s say the money that you need over the next 5-10 years goes to fixed deposits. Anything longer, you consider some exposure to equities. Mathematically, there is not much difference between (2) and (3). However, in terms of investment behaviour, this may just be the right medicine. You won’t be as much worried about market movements if you know that you won’t need to touch these investments over the next 10 years. This approach can be extremely useful during retirement.
What should you do?
Whichever approach you use, stick with it.
Don’t try to be someone else.
There is no dearth of retail investors whose risk tolerance automatically goes up when the markets are hitting new highs every day. These investors never looked beyond bank fixed deposits/PPF/EPF in their lives. Suddenly, they think you can’t go wrong with equities. We all know the result for such investors. When they lose money, fear replaces greed. They panic and exit taking huge losses. Such investors either never come back or come back when the markets are again hitting new highs for the cycle to repeat.
As an investor, you can go through the most complex risk profiling questionnaire, you will get to know of your real risk tolerance only when you see deep red in your portfolio. Therefore, give yourself time to understand the kind of investor you really are. Unfortunately, even professionals can’t help you there. They can’t figure out before you figure out.
You may a young investor or an old investor who is planning to invest in equities for the first time. If you are new to equity investments, do not dive headlong. Start small. Make a small allocation. As you learn more about your true risk tolerance, you can tweak your allocation.
The best portfolio for you is the one that lets you sleep peacefully at night.