Stock markets: Ways to know your risk appetite

Life is really simple, but we insist on making it complicated, said Confucius, centuries ago. Why? Because we don’t value simplicity. Let me ask you a question. “How many of you would agree that eating healthy food, maintaining a healthy routine and investing in quality assets with predictable returns are the right things to do?” I am sure, most of you have an affirmative answer to this question.
Now, let me ask my follow-up question. “How many of you maintain good food habits, maintain good health routine and invest in quality assets?” Oops!The numbers are down drastically. Most of us are likely to flunk in our food habits, maintaining health routine and in our investment behaviour. Let us focus on our investment behaviour only.

Importance of asset allocation

We know that asset allocation explains more than 90% of the variation in our investment returns and one should follow an asset allocation consistent with his risk profile and financial goals. Equity has to be an integral component of the asset allocation as it is one of the few asset classes that have a potential of delivering inflation-beating returns by a wide margin and create wealth in real terms for investors.

Two-stage investment process

We follow a two-stage investment process: Stage 1: Asset allocation and Stage 2: Investment choice within the asset class. That translates to putting 40% of my money in equity and within equity, allocate money between large-cap and small-cap equally.

For an investor with a given risk budget/risk tolerance, has two alternatives. First, be extra conservative at asset allocation stage and be very aggressive within the asset class; second, be reasonable at an asset allocation stage and be conservative while investing within the asset class.

Most of us go for the first approach as we have seen at the beginning of the article. We invest less in equity than what is optimum consistent with risk profile. Equity, after all, is a volatile asset class and investors by nature are averse. However, when it comes to allocating funds within equity, the same risk-averse investor behaves differently. Instead of investing in a portfolio of blue-chip stocks, he starts investing in hot stocks or penny stocks in the pursuit of the nectar that can make him rich soon. He treats equity as “Risk Capital”.

The second approach, calls for more investment in an asset class like equity, but then controlling risk by investing in a portfolio of less volatile/risky stocks and thereby treating equity as “growth capital” rather than “Risk Capital”

Which approach is better?

Now if risk and return have a positive relationship, then both approaches are fine and an investor can choose either of them based on his comfort. But unfortunately, there is no reward for taking higher risk, especially when it comes to equity as an asset class. Making the things worse, the relationship turns on its head and higher risk leads to lower return.

You can see the chart showing annualised volatility and return for Nifty Low Volatility 50 Index and Nifty High Beta 50 Index As you can see, the index representing low-risk portfolio has constantly delivered superior returns with much lower volatility. Given this reality, an investor using the first approach is most likely to lose money by treating equity as risk capital and the stock market as a casino.
He would exit equity wounded and vow never to invest in equity ever again nor advise anyone to do so. Given the reality, it is always better to allocate more funds to equity as an asset class, and control risk by investing in a portfolio of low-risk stocks. That will provide you an opportunity to create wealth from higher allocation to equity at an asset allocation stage and by investing in high return without high-risk equity portfolio within equity as an asset class.

The message is clear: Have a simple plan for good food habits, health routines, and good investment behaviour and implement it very seriously.