You should buy an investment product that suits your risk appetite, so you are told.
This statement presupposes that you know your risk appetite, and that your risk appetite does not change with time, even if you invest in a product through a long-dated systematic investment plan (SIP).
Suffice to know that determining your risk appetite is difficult because of behavioural reasons. Also, your risk appetite will change over time due to factors other than aging. In this article, we explain why buying an investment product is more a function of your life goal than your risk appetite, when you self-manage your investments.
Goal pitted against risk
You cannot pursue all your life goals because you have to balance your current lifestyle and savings.
This forces you to prioritise your goals. How do you decide on goal priority? A simple test is to ask a question: can your goal be postponed? If not, then the goal is high priority. Your child’s college education fund, is an example.
Suppose your current high-priority goal is to accumulate ₹1 crore as down payment to buy a beach house eight years hence.
Given your current lifestyle and your income levels, you can save, say, ₹75,000 each month to achieve this goal. So, a compounded annual return of 8.5% on your savings will help you accumulate ₹1 crore at the end of eight years. You believe that investing in equity is risky and prefer bank deposits.
But bank deposits earn a pre-tax return of 5.75% and a post-tax return of 4%, assuming a marginal tax rate of 30%.
Given that you need 8.5% post-tax returns, yielding to your perceived risk appetite means you will fail to achieve your goal. Surely, you cannot give up on your high-priority goal because of your presumably low risk appetite. What should you do?
Present versus future
You have two choices: increase your monthly savings so that earning 4% on bank deposits will help you accumulate ₹1 crore in eight years.
Or, invest in products that can offer higher returns but carry higher risk. Now, curbing your current lifestyle to save more is easier said than done. You could marginally increase your monthly savings, but you may still need to invest in risky investments (read equity) to achieve your goal. That said, how should you choose your equity investments: active funds or index funds? Note that index funds carry market risk viz. the risk that the fund will decline in value along with the broader market.
In addition to market risk, active funds carry active risk viz. the risk that the fund could underperform the benchmark index. You may want to settle for only market risk, given that you have to invest in equity despite your concern for such investments.
And that means choosing a large-cap index fund. The risk of investing in a large-cap fund is the price you pay for your current lifestyle.
That is, less savings means better current lifestyle as you spend more of your income now, but that forces you to invest in equity to earn higher returns.
Your risk appetite is not a factor you should consider when investing to achieve high-priority goals. The argument is simple: if your savings cannot help you achieve your high-priority goal with bank fixed deposits, then you have to invest in equity.
If taking risk can help you improve your chances of achieving your goal as well as balance your current lifestyle and savings, then not taking risk is risky. So, start your equity SIPs sooner than later.
(The author offers training programmes for individuals to manage their personal investments)