The thumb rule, more risk means more reward, is always misinterpreted. There is a fine line between risk and calculated risk. Many fail to realize that it’s calculated and strategic risk that can yield higher reward and this can only be obtained through behavioural finance-driven asset allocation.
For designing a standard asset allocation, investment advisers try to gauge the risk appetite of the customers and discuss their financial goals. Though this is the traditional approach, the risk tolerance questionnaire is often misinterpreted. Currently, common risk questionnaires do not address behavioural biases. The last four years have proven that behavioural biases in investments are essential in creating the right asset allocation. The only certainty among uncertain markets is the behaviour of investors. The fear of losing money dominates the desire to make money. Despite the importance of this, advisers often ignore it.
It is important that behavioural finance should be given the same weightage as the modern portfolio theory is given. An optimal portfolio can only be obtained with a blend of the modern portfolio theory and behavioural finance.
Here, diversification becomes important as it ensures that though there is dip in returns, the capital is always protected. This helps people to hold on to their investments even in the bad period to enjoy the benefits during the good times that follow. Let’s see how asset allocation and behavioural finance can be brought in sync through a real case study.
A 30-year-old financially well-informed professional invested Rs.1 lakh in equity funds in November 2006 on the advice of an investment adviser. He invested Rs.25,000 each in an infrastructure fund, an India advantage fund, a large-cap fund and a multi-cap fund. By March 2007, his portfolio value diminished to Rs.92,736. If he had continued with his allocation, which is most probable given his risk appetite, his portfolio value would have further reduced to Rs.65,785 by September 2008.
Luckily for him, he approached a financial planner. Considering the macroeconomic events of March 2007 and his behavioural bias, his personal finance adviser recommended him a long-term portfolio with 15% in large-cap equities, 10% in mid-cap equities, 25% in index funds, 10% in commodities and 40% in debt. Result: the portfolio value was Rs.1,31,782 even during the recessionary October 2008 period. The recommended portfolio ensured that the capital is always protected and matched the person’s risk tolerance.
But how did the financial planner estimate the person’s risk tolerance and hence, arrived at the solution?
The importance of diversification stressed by the modern portfolio theory was implemented against the irrational behaviour of the customer, which was biased towards equity. Any asset allocation software based on the modern portfolio theory would have recommended a portfolio inclined to debt (during 2007-2008). But the behavioural tendency of the customer would have made him redeem his investments in debt at the first sign of recovery of equity markets. In order to overcome this behavioural tendency of the customer, a long-term horizon was advised.
The case study throws up an important observation that diversification or asset allocation over the long-term counters behavioural biases which is key to pushing investors into a selling mode, at the wrong times. A good allocation ensures that the investor stays invested for a longer period of time allowing them to enjoy the benefits of compounding. Investing in a single asset class is subjected to either high volatility and loss or diminishing returns that even fail to keep pace with increasing inflation. A well-defined diversified portfolio reduces volatility and ensures stability. A long-term horizon ensures that the effect of inevitable market volatility is minimized.
Nitin B. Vyakaranam is CEO, Arthayantra.