Investors have varying levels of risk tolerance. Some people don’t blink when their portfolio plummets by 25-30%, others worry when their portfolio drops by just 0.5%.
The first group of investors is likely to be experienced investors, while the second group of investors has a lower risk tolerance.
How should investors with low risk appetite and tolerance invest their money? Should such investors invest in stocks and equity funds?
Before I get there, I’d like to contrast risk-taking ability with risk tolerance/appetite.
Risk-taking ability and risk appetite/tolerance
Risk-taking capacity refers to how much risk you can take and depends on factors such as your age, net worth, cash flow, financial goals and family circumstances.
Suppose A and B need 100 million rupees as retirement allowance. At retirement, A’s net worth is Rs.100 million and B’s net worth is Rs.100 million. B’s risk-taking ability is clearly higher than that of A. Even if B loses some money, he still has money for a comfortable retirement. Mr. A does not have such luxury.
All else being equal, the ability to take risks against long-term goals is higher than the ability to take risks against long-term goals. In the short term, volatility is a risk. On the other hand, in the long term, volatility can even be on your side.
Risk tolerance is how you react/behave when the market moves in the opposite direction. If you remain calm at such times, you have a high risk tolerance. Panicking lowers your risk tolerance.
By the way, investors with low risk tolerance generally don’t need to be risk averse. It’s not that they don’t make risky investments or make risky decisions. It’s just that they have a hard time dealing with stock price volatility.
Consider some examples.
Real estate prices are also volatile. However, since the market price of the property does not change from moment to moment, it is okay to hold real estate for a long time. More importantly, there is a certainty (which may not be true) that real estate prices will always go up. Whatever the reason, it helps you hold real estate (floating assets) for the long term and ignore volatility.
Due to my profession, I interact with many entrepreneurs and professionals (non-salary workers). While they battle the risks associated with their jobs (and choose a riskier career path for him), not all are happy when it comes to investment volatility. Amazing, isn’t it? Perhaps they want control. If there was something wrong with their business, they could at least do something about it. not. After all, it was the same as it was days, weeks, or months ago. Even if you could, there’s very little you can do. Someone else is running that business and the stock market can become irrational.
It may also be about perception. They may not consider real estate investments or businesses to be risky.
Whatever the reason, investors with low risk tolerance for equity investments can see what they can do. Here are some ideas.
Approach #1
You don’t need to invest in the stock market if you can’t digest market volatility.
We may have to give up the potential for greater returns that the stock market offers, Avoiding stocks altogether is a million times better than selling stocks at market lows (buying high) because of fear. If you buy high and sell low, you will not make a profit.
Also, it doesn’t mean that you can’t achieve your goals if you don’t invest in stocks. Our parents never invested in the stock market. Aren’t they leading a comfortable retirement? I’m sure many of them do. Otherwise, it’s unlikely to be a reason not to invest in stocks.
Suppose you want to save Rs 100 crore for retirement in 20 years.
#1 You invest in a multi-asset portfolio (let’s just equities and liabilities) and expect a 10% after-tax investment return. I have to invest around 14,000 rupees every month and I live a precarious life.
I’m guilty of portraying volatility as harmless, but short-term volatility is less of an issue for patient investors in the accumulation phase. For such investors, losses are only hypothetical. On the other hand, for an investor exiting a portfolio (depreciation mode), market volatility leads to a real risk of missing the target (not enough money or too early).
#2 Avoid all volatility and simply invest in EPFs, PPFs and bank term deposits. Earn 7% annual interest on your investment. In this case, you will need to invest around 20,000 rupees monthly to reach your goal in 20 years. So you have to invest Rs 6,000 more and that’s fine. No need to worry about volatility.
So if you check your stock portfolio five times a day or lose sleep when your stock investment drops, there’s little point in investing in stocks and mutual funds. please stay away
Approach #2
You invest in the stock market only a portion of your assets that you are not worried about. It can be 10% or 20% or whatever makes you happy. Many of us think of lotteries that way, albeit for much smaller amounts.
A good percentage for you is a percentage that you don’t mind checking the value of your stock investment for a few years. You can rebalance your portfolio regularly to keep your equity distribution within your comfort zone.
Approach #3
Divide your investment into buckets.
Let’s say the money you need for the next 5-10 years goes into a fixed deposit. If it’s more than that, consider exposure to equities. Mathematically, there is not much difference between (2) and (3). But when it comes to investment behavior, this may be just the right medicine. If you know you won’t need to touch these investments in the next 10 years, you shouldn’t worry so much about market movements. This approach can be very useful when you retire.
what should you do
Whichever approach you use, stick with it.
Don’t try to be someone else.
Many retail investors automatically increase their risk tolerance when the market hits daily highs. Greed begins. These investors have never looked beyond bank term deposits/PPF/EPF in their lives. Suddenly they think stocks can’t go wrong. We all know how it ends for such investors. When they lose money, fear replaces greed. They panic and exit with huge losses. Investors like that never come back, or come back when the market hits new highs again and the cycle repeats itself.
Investors can answer the most complex risk profiling surveys. Only when you see a deep red in your portfolio will you know your true risk tolerance. So give yourself time to figure out what kind of investor you really are. Unfortunately, even experts cannot help you. They don’t understand before you understand.
You may be a young investor or an older investor planning to invest in stocks for the first time. If you’re new to stock investing, don’t jump headlong. Start small. Make small allocations. As you learn more about your true risk tolerance, you can fine-tune your allocations.
The best portfolio for you is the one that will give you a good night’s sleep.
Seek professional help if you are still unsure about your approach. The cost of good investment advice is much lower than the cost of bad investment/financial decisions.
Main image credit: Unsplash
This post was first published in May 2019 and has since undergone minor updates.