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What should I Invest In?

>> Thursday, January 21, 2010

The textbook answer, according to many "financial planners", is to first determine your risk appetite and then design a portfolio of funds consisting of a proportion in equities and bonds depending on the results.

In a nutshell:

To determine the risk appetite, a standard questionnaire is normally used which covers areas like age, investment horizon, real life choices, probability pay-off tolerance, etc. Then a score is computed showing if you are risk adverse, balanced, conservative or  aggressive.

Subsequently, a portfolio consisting of 70% bonds - 30% equity for adverse; 50% bonds - 50% equity for balanced; 30% bonds - 70% equity for conservative; and 100% equity for aggressive.

In my opinion, this approach does not make any sense at all.

Firstly, risk taking is affected by so many factors as highlighted in my earlier article of limitations of rationale thinking. Therefore, how accurate are these questionnaires in measuring ones risk. And as illustrated later, the results mostly do not reflect one's approach towards risk management.

Secondly, I believe everyone is inherently loss adverse. Regardless if you are risk adverse or aggressive, all rationale people do not like to lose money. Hence, if we are all the same, profiling our "risk appetite" should not determine how we should invest.

Thirdly, I believe that diversifying into the "balanced" portfolios is actually doing more harm. Normally, when bond outperforms, equity under performs and vice-versa, they are negatively correlated. As a result, investing like that increases your risk with no significant improvement in returns.

So, how then should I invest?

Step 1. Ensure your emergency cash reserves and protection plans are in place.
Step 2. Determine your investment objective and time horizon. i.e. for retirement planning or for current income and what is the time frame.
Step 3. With a long time horizon and the objective of retirement planning, focus on capital appreciation (100% equity). With a short time horizon and objective of saving for a specific purpose, focus on capital preservation (100% money market). With an objective of current income, focus on high yield investments (100% bonds or dividend yielding equity like REITs).

As this is a deviation from the textbook answer, it SEEMS risky.

Well, consider this. If your time horizon is long and objective is retirement planning BUT you are risk adverse, you only invest mainly in bonds, you will only achieve modest capital appreciation and what do you need the current income for (if all your reserves and protection plans are in place)? It will be even risky that you are not able to achieve better returns.

Leaving your cash and current income idle because you are risk adverse will only let inflation erode its value away. What do you need the extra cash for anyway? Just to admire a fatter bank balance? Just to satisfy your need to see an immediate growth in your capital? If all the proper financial plans are in place (like cash reserves, budgeting, insurance), even if your investment drops in value, you have no immediate need of the extra cash, accept the short term fluctuations and focus your investments to meet your objectives of higher returns.

What the risk appetite results should be use for is to determine the risk management approach one should adopt. i.e. if you are risk adverse, you will need a more comprehensive insurance plan whereas if you are aggressive, you are willingly to retain the risk through self insurance. Surprisingly, many can be risk adverse, but adopt a risk retention through ignorance approach for their protection (meaning they take the "cow boy style" of self insurance by believing nothing will happen to them).

In conclusion, do not allow your perceived risk appetite to hamper your investment style. It should be focused based solely on the time frame and your objectives to achieve the most suitable returns.




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