Emotions can colour your decisions

Risk is the flip side to return. But you already knew that! So, how do you factor risk in your investment decisions? This question assumes importance because of two reasons.

One, your risk perception typically changes with wealth; you will be more willing to take risk when you feel abundant than if you don’t. And two, your risk factor is tiered — it is different for each life goal. In this article, we discuss why your risk factor is tiered, how your risk perception changes and how to incorporate these factors into your investment decisions.

We will divide your risk factor into two components — hard and soft factors. Hard factors refer to those that can be quantified such as your investment horizon and your income potential. Soft factors, on the other hand, are psychological.

Sometimes, the feeling of abundance may drive you to take more-than-usual risk. At other times, despondency could drive you to make very conservative investments.

Now, consider two life goals — your child’s education and your retirement wealth. Suppose you need ₹1 crore for your child’s college education in ten years, and ₹15 crore in your retirement account in 25 years. Clearly, you cannot have a single portfolio to meet both these life goals. Why?

One, the investment horizon for both goals is different. Longer time horizon gives you better chances of recovering losses on your equity investments.

Two, your investment priority is also different. You can, if required, postpone your retirement date. But you cannot possibly defer your child’s college education because your education portfolio performed poorly!

The above discussion leads to two important inferences. One, your risk-taking ability increases with investment horizon; longer the horizon, greater the risk-taking ability. And two, your risk-taking ability decreases with the importance of your goal; more important the goal, lower your risk-taking ability. Note this argument is independent of how much you earn or what your current wealth is.

Needless to say, your perception of wealth and income levels also determines your risk factor. You are likely to take more risk when you have other positive factors happening in your life. In contrast, you are likely to make conservative choices when life’s goings-on makes you vulnerable and scared.

Suppose your portfolio carries large unrealised gains. The feeling of abundance that comes from the unrealised gains can prompt you to buy more risky investments, and, perhaps, even spend more!

But you will not always take more risk when your portfolio has large unrealised gains. If you have had a major let-down in your personal life, the anxiety could rub off on your investment decisions, prompting you to take profits sooner than later on your investments!

The point is this: your state of mind can sway your risk factor. And that may reduce your chances of achieving your life goals. Suppose your sense of vulnerability prompts you to take profits on your equity investments in the current market condition. You may derive emotional satisfaction and, perhaps, even relief from reducing the perceived risk of losing unrealised gains.

But if you invest the sale proceeds in bank fixed deposits, you may have sabotaged your chances of achieving your life goal, if the required return on your investment portfolio is higher than the interest earned on your deposit.

You should consider only hard factors while making your investment decisions. Importantly, you should moderate the effects of soft factors to improve your chances of meeting your life goals.

One way to do so is to set up systematic investments and adopt rule-based profit-taking. That way, you will have to simply implement rules designed when your anxiety and stress levels were low. And remember: your hard factors are different for each of your goals.

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in

COMMENT NOW