Most people's risk tolerance is actually zero. You could be financially very stable and yet be completely averse to the idea of losing money. The solution is to adopt time-based asset allocation
29-Mar-2007 •Dhirendra Kumar
Some days back I got an email from a young man who recently won a good amount of money in the quiz game show Kaun Banega Crorepati. While the amount of money he won is not even close to the ultimate prize of the show, it is certainly enough for this teenager to finance as good an education that he wants for himself. He wanted to talk to me to get investment advice on how best to invest and preserve the neat little nest egg that Mr Shah Rukh Khan had presented him with.
The conversation I had with this boy reinforced my feeling that the cult of the expert - the firm belief in an outsider who knows everything - is distorting how people (specially intelligent people) approach investment. There's a strong idea around that there are some universally good investments, and that there are experts who know what these investments are, and all one has to do is to ask an expert and he or she will tell you and that is that.
This would be very convenient but it's unfortunately not true. The question whose answer we all need is not “Which is a good investment” but “Which is a good investment for me?” This seems like a trivial and self-evident point but is somehow only paid lip service to. There are no universally good investments. The most important part of that question is 'for me'.
But what is it about you that decides which investment is good and which is not? Conventionally, the big role is played by something called your risk tolerance and based on that, a financial planner can work out what kind of investments you need. This is a bogus concept. Most people's risk tolerance is actually zero, and the more inexperienced you are as an investor, the more likely that any kind of loss will make you run. The reason is that what the conventional financial planning measures is your financial risk tolerance whereas what actually matters is your psychological risk tolerance. You could be financially very stable and yet be completely unable to tolerate the idea of any investment losing you money.
The solution is to adopt what we called time-based asset allocation and continuous rebalancing. The idea is that you should try and divide up your investments into portfolios that are meant for different time-periods and put them in investments with different levels of risk based on how much time is it before you need the invested money. Moreover, this allocation must be rebalanced at least once a year. This way, you will end up booking profits and buying investments at low prices automatically.
One habit which leads most of us into panic is the habit of considering our investments on an individual basis rather than as a portfolio. There's a little point in investing some money in equity and some in debt if you keep expecting both to always make money independently. It's a portfolio, and the debt part is there to provide some stability when the equity is tanking.
By the way, while there may not be any universally good investments, the reverse is not true. There are universally bad investments. If you ask me for a list of investments that no one should ever make, I could come up with a fairly long one without much of a problem. I wonder if there's a lesson in that.