Could it be that we’re putting the cart before the horse?
Financial planning theory recommends a methodical approach to investing
Step 1. Risk Assessment: each investor should estimate their ability to take risk – usually done by the investor answering a set of questions such as: “Would you rather invest in a portfolio that returns 10% each year or returns 30% in one year but loses 20% in another.”
Step 2. Asset Allocation: Based on the risk assessment score, each investor should decide which asset class (Equity, debt etc) they should invest in and how much. (90% Equity+10% debt OR 70% Equity+30% debt).
In my opinion, there is a problem with this approach and let me explain it with an example of two people:
A & B are both 28 years old, married to working spouses with a family income of Rs 1 lakh a month. However, based on their individual risk assessment A invests in 100% equity and B invests in 50% equity & 50% debt. Both save the same amount viz. 30% of their income and both their incomes grow by 10% a year.
At age 60, the nest egg of A is likely to be almost twice that of B and B would struggle to maintain their lifestyle after retirement.
Would you say that person B “deserves” this because they did not have the ability to take risk?
In my humble opinion that’s the wrong way of looking at the situation. Financially speaking, both had the same “ability” but different “attitudes” to risk. The “ability” to take risk should be an objective measure – determined by how much money you have AND whether you have a source of income to make up for a loss in investment.
And Asset Allocation should be driven by what you “need” rather than what you would “like to”. Therefore the asset allocation for both A & B should be the same.
I know this is controversial and I would love to hear from you on this.
(There is a related discussion on the riskiness of asset classes here, stoked by none other than Warren Buffet)