Every investment has return expectations. While large negative deviations in the short-to-medium term are common in stock market investments, they often revert to the mean return expectations over the investment horizon. The uncertainty of returns and the deviations is referred to as risk.
The Nifty 50 exchange traded fund has provided annualised returns of 12 percent over a 10-year horizon. However, these 10 years are generally marked by short-term volatility with losses of 10-50 percent once in a while before recovering and reverting to the average long-term trend. To successfully leverage the return potential of the Nifty 50 ETF, the following rules must be observed:
- Ignore short-to-medium term spells of deep market corrections. Treat them like a fixed deposit, where withdrawals are not allowed.
- Treat market declines as a bargain offer to get new units at lower prices.
However, if an investor’s risk appetite is too low to tolerate short-term losses, ETF holdings would be sold prematurely at the occurrence of a negative event and losses would be booked, leaving a big hole in wealth.
Adding sanity
Traditionally, retail investors are driven primarily by return considerations. In their search for returns, they often end up with a portfolio that is riskier than their actual (but unknown) risk appetite and they end up exiting the investments at losses in the case of negative risk events.
Whether it was the small-cap funds in Q4 of 2021 or crypto at the beginning of 2022, most terrible investment decisions by a majority of investors are driven by risk appetite ignorance and the obsession with high returns. In general, investors end up playing blind in the hope that high returns of the past would continue in the future without any consideration of risk appetite for negative risk events. Risk appetite ignorance ensures that a normal negative risk event becomes a risk shock for investors.
Risk assessment is a simple yet clever hack that addresses the risk appetite ignorance woes of investors and adds a degree of professional finesse to portfolio construction. Risk assessment provides investors with knowledge about their risk-taking capability and helps them decide whether an investment is suitable for their portfolio. It ensures a low probability of risk shocks and allows portfolios to stay on course towards long-term wealth-building without being bothered by short-term bear markets and corrections.
Risk assessment forms the foundation of a sophisticated three-step risk-centric portfolio construction process that is practiced by professional investment advisors and experts:
1) Investors undergo risk assessment and their risk-taking capability is determined. This risk level serves as a target risk for the investor.
2) Investment portfolios with historical risk levels equivalent to the target risk level are selected for step 3.
3) An investment portfolio with a track record of providing the highest returns is selected.
This approach driven by risk assessment ensures that investors are not spooked by short-term volatility surprises or risk shocks and they get an optimal portfolio designed to maximise the return potential within a specified target risk. With investment losses broadly remaining in the expected ranges, risk assessment adds a sense of consistency, scientific temper, discipline and purpose to portfolio construction and significantly improves the odds of realising the promised return potential.
Portfolio personalisation
Two individuals can have significantly different personal/financial realities even if they come from the same socio-economic strata. Personalisation is the core essence of the risk assessment approach that not only allows it to design an optimal investment portfolio but also improves the probability of success vis-à-vis other approaches driven by a one-size-fits-all mindset.
For example, X and Y are of the same age and have similar salaries. X inherited a house while Y had to take a home loan for a similar house and 40 percent of his monthly income goes into home loan EMIs. Risk assessment dictates that X, with a higher savings rate and no liabilities, can afford to take a higher risk (relatively higher allocation to stocks or riskier segments like mid-cap/small-cap) vis-a-vis Y. Risk assessment enforces an investment portfolio that is aligned with the personal and financial realities of investors.
Moreover, financial and personal situations evolve. Continuing our example, the risk-taking capabilities may change if Y gets a 100 percent salary raise or if X becomes a father to triplets.
Risk assessment is not a one-time activity. To harness its full potential, risk assessment must be undertaken after every critical financial/personal event. It allows risk assessment to retain its edge as an effective tool for the creation and maintenance of an optimal investment portfolio throughout the investment horizon.
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