Risk: An Underrated Word in Today’s Investment Landscape

Regardless of the method, this exercise is crucial as it leads to a recommended asset allocation that is potentially suitable for the client’s long-term investment strategy. Asset allocation is a cornerstone of any sound investment plan. However, the relevance of this exercise diminishes if an investor is exclusively looking for equity investments or if the advisor is focused solely on stock recommendations.

It is also important to recognize that answering a series of questions may not fully reflect an investor’s risk tolerance. True understanding develops over time, particularly when the advisor and investor have experienced different market cycles together. These shared experiences reveal deeper insights into risk perception and lead to a mutually accepted asset allocation. Observing reactions during market downturns and upturns is essential.

For example, investors who were conservative during the COVID-19 crisis have now turned aggressive and are seeking maximum equity exposure. If an advisor suggests otherwise, taking into account their objectives and risk profile, these investors might ignore the advice and opt for direct equity exposure through risky products such as portfolio management services (PMS), alternative investment funds (AIF) or even futures and options (F&O).

The recency effect

New investors who entered the market after 2020 have yet to experience a significant downturn. Consequently, they may not fully understand the concept of risk. Armed with information from free tools and a wealth of online resources, they often feel confident in navigating market challenges – sometimes with misplaced confidence. Many trade derivatives without fully appreciating the potential for loss.

In today’s environment, investors are faced with numerous distractions. Some are driven by cost-saving motives, such as avoiding advisory fees or fund management charges. Others are swayed by a superficial understanding of diversification or the allure of new investment opportunities through new fund offerings and initial public offerings. Buzzwords such as “defense,” “solar energy,” and “electric vehicles” dominate their investment decisions, creating a false sense of security, as if they have discovered the path to financial nirvana.

This phenomenon can be attributed to the “recency effect,” a cognitive bias whereby more weight is given to recent information than to past experiences. In a bull market like the current one, the possibility of a recession seems remote to them, leading to complacency in risk management and an overemphasis on risky investments. Conversely, during a market downturn, fear of loss leads investors to opt for safer options, often also ignoring the risks inherent in those options.

Such one-sided approaches rarely lead to long-term success. That’s why investment advisors who practice financial planning continually encourage their clients to adopt a disciplined, process-oriented approach to investing.

These are tough times for real advisors. Their role goes beyond helping clients grow their wealth; they are also the guardians of their clients’ financial well-being, working to prevent significant losses. Advisors often recommend rebalancing portfolios (selling stocks to buy defensive assets), but investors may balk, reluctant to reduce their equity exposure while expecting double-digit returns. Some may even ignore this advice and venture into direct equity investments through brokers or platforms like Smallcases.

Risk profiles

Risk profiling is similar to having your blood pressure checked before prescribing medication, and asset allocation is like maintaining a balanced diet. If you have high blood pressure and don’t eat a proper diet, the consequences may not be immediately apparent, but you are likely to suffer long-term damage to your organs. Similarly, balance is key to a healthy financial life.

Even if you have normal blood pressure, maintaining your health requires a combination of proper diet, rest, and regular exercise. The same applies to achieving long-term financial goals: consistent, regular investments, along with an understanding of known and unknown risks, are essential. Known risks can be controlled, but it is the unknown and invisible risks that pose the greatest threats.

Never invest too much in volatile asset classes in order to achieve your goals more quickly. While this strategy may yield occasional results, it is not sustainable and could cause significant long-term damage to your assets.

Furthermore, it is essential to recognise that risk is not a static concept – it evolves over time, market conditions and personal circumstances. What may seem like a tolerable risk today can become an overwhelming risk tomorrow, especially when life events such as retirement, health issues or unexpected expenses come into play. Therefore, it is necessary to periodically review and adjust the risk profile and asset allocation to ensure that they are in line with changing realities.

Investors often underestimate the value of professional advice, especially in a bull market when everyone seems to be making money. However, it is in these moments of exuberance that the seeds of future losses are often sown. The role of a professional advisor is not only to guide through the complexities of investing, but also to act as a voice of reason, ensuring that enthusiasm does not cloud judgment.

The true test of any investment strategy is not how well it performs in good times, but how well it holds up in bad times. This is where understanding and respecting risk comes into play. Those who dismiss risk as an unnecessary consideration may find themselves caught off guard when the market inevitably takes a turn.

In conclusion, risk is a fundamental aspect of investing that should never be underestimated. It requires constant vigilance and careful management. By respecting risk and making informed decisions, investors can build resilient portfolios that stand the test of time and achieve their financial goals without compromising their peace of mind.

Manikaran Singal is the Principal Director of Good Moneying Wealth Planners Pvt. Ltd, a Sebi registered investment advisor.