Few can afford the luxury of being risk averse

Investors need to be mindful of the future costs of inconsistent behavior

By Priya Sunder

Investing through a structured planning process is the best way for people to meet various goals in their lives. Without a plan, an investment is simply a transaction with no specific direction. Such investments, perhaps, make sense for people looking for capital preservation because they don’t need growth; or for people looking for growth, because they have adequate assets in risk-free investments. For everybody else, who need direction in determining and maintaining the right blend of safety and growth in their portfolios to meet life goals, financial planning is the way to go forward.

In order to create and administer a properly structured plan, one must understand the client’s goals, determine the risk required in the portfolio, the right asset allocation and then specific instruments. Hence, it is the goals that drive the level of risk, and not the other way around. Only when an advisor aligns the goals, risk requirement and risk appetite of the client, will he be able to construct optimal portfolios.

Easier said than done. The problem with most plans is that an investor’s risk tolerance varies constantly during the investment journey. It is common to hear from clients during the planning process that they are willing to take high risk for a high return but when the rubber hits the road, and the markets go through the kind of turmoil as today, their risk tolerance drops drastically. Alternately, an investor’s risk appetite and risk requirement may be low, but they are disappointed when the portfolio generates single-digit returns.

Mr X, a client, called me recently in panic and said he wanted to sell his entire equity mutual fund portfolio and invest it in fixed deposits. The market drop in the last few months had brought him to this interesting conclusion that he would be better off playing safe.

Here is the situation. Mr X has about a decade more to go before he retires. His financial portfolio requires 40% exposure to equity to meet his retirement goals. His current portfolio is perfectly balanced between equity and debt. He now wants to go 100% debt and 0% equity. If I let him have his way and move all his assets to debt, he would run out of money seven years into retirement. The withdrawal rate required to meet his expenses would not match the growth in the portfolio. In order to meet his expenses comfortably, his portfolio would need to grow at more than twice his withdrawal rate. To match this required growth rate, he will need to have a blend of both equity and debt in the portfolio, in the right ratios.

What should an advisor do in such a situation where her client’s risk appetite does not match his risk requirement? Here are the options: 1) Acknowledge the client’s nervousness in volatile markets, change the portfolio to accommodate his wishes and move the portfolio to risk-free assets. This could mean that the client may not achieve his long-term retirement goals because the overall returns may fall short of the required return. 2) Hold your ground, advise the client to avoid knee-jerk changes to his portfolio and encourage him to stay the course of the plan. 3) Incorporate the client’s inputs, re-craft the plan, revise his goals and inform him that though he may not sustain his current lifestyle after retirement, he will be able to afford a lifestyle a few notches lower.

Option 1 does not work. Investing in line with Mr X’s risk appetite, which keeps fluctuating through market cycles, will make his portfolio either too risky or too safe and may compromise his financial independence. Also, financial advisors are not order takers. They understand your desires and goals, assess your financial situation and create a road map to help you get to your goal in the most efficient way. If investors knew what is best for them, they would be better off without an advisor’s help.

I would go for Option 2 or 3. Option 2 helps the client stay true to his plan and prevents him from changing course each time the market shifts. Option 3 meets the advisor and the client’s requirements midway, though it may not deliver the most optimal or efficient return on his portfolio. However, this option may lead to moving goalposts if the client’s risk appetite does not stay consistent.

In conclusion, risk aversion is a luxury few can afford. Investors need to be mindful of the future costs of inconsistent behavior. They would be better off fastening their seat belts, staying the course and driving towards their goal. If not, they will lose control of their plan, and get taken for a ride instead.