Goals and Risk Profiles II

Last week, we explored what a risk profile means, its implications on your asset allocation and also debunked a myth that your risk profile is linked with your age. Here’s a quick recap of it. Alternatively, read through the entire article here.

  • Key factors determining your risk profile are
  1. Your future financial goals
  2. Your Emotional Quotient
  3. Time spent by you analyzing and researching investments
  • Debt Investments – lower risk, potentially lower (but stable) returns
  • Equity Investments – higher risk, potentially higher (but unstable) returns
  • Your risk profile (amongst other factors) determines your asset allocation

If you resonate with the above, then congratulations! You are out of the Matrix.

I can estimate my risk profile now but what are financial goals?

A financial goal is a destination. Investing is a journey to that destination.

We all learn the concept of saving since childhood. Remember your piggy bank where you saved up to buy an action figure toy? That’s a financial goal.

But let us define it in more detail. A financial goal should have

  1. The “what” – A purpose – could be a vacation, education, marriage, your retirement (or financial independence as we call it), just about anything that money can buy you
  1. The “when” – A time horizon – you wont wait indefinitely for that vacation, would you? You have to visit Disneyland before your kids outgrow it. Some goals like a vacation have flexible timelines – missing them by a few months wouldn’t matter. But some goals like paying for your/your child’s education have hard timelines that are completely inflexible.
  1. The “how much” – An Amount – of course, you need to quantify your goal

Why should I define financial goals?

Defining financial goals helps you allocate investments with the specific purpose of meeting those plans. A financial goal is the answer to the questions “Where do I invest?” and “How much do I invest?”. This table should give you the gist.

GoalTimelineAmountDebt Allocation *Equity Allocation *
Europe Tour2 years from now5,00,000MoreVery low to nil
Car6 months from now10,00,000MoreNil
Buying a house5 years from now1,00,00,000LessMore
Child’s education15 years25,00,000LessMore
Retirement (We don’t like this word, more on it later)35 yearsHow the hell do I estimate this? We have a blog coming up on this soon!LessMore

*How much “less” or “more” debt and equity allocation is determined by your risk profile.

Are you seeing a trend here? The shorter the timeline of the goal, the higher the allocation towards debt. This is because investments in equity can lead to erosion in principal over a short term. Over a longer term, equity provides higher return than debt.

How should I go about defining financial goals?

There are some goals in life that you will have to meet. Come what may. Plan for those goals first. The order of preference, in my opinion, should be as under:

  1. Retirement – Whatever you do, a day will come when you have to retire. Your current income stream from active work will stop. This is inevitable. Plan for it!

Side note: We do not like the word “retirement”. We believe in financial independence itself. Retirement is forced on you, retirement makes you less active. Financial independence is achieved by you, not imposed on you. It enables you to pursue whatever you wish.

  1. Child’s education – We all want the best for our children, don’t we? Again, educating your children is inevitable.
  1. House – Buying a house is a dream for all of us. But it’s not inevitable. You can always live in a rented house. Hence, the other 2 goals take priority over this.
  1. Child’s marriage – We all want to save for this. It may or may not be inevitable.

These 4 life events are important, and hence should be planned for. Once that is done, shorter term goals (which I call as consumption goals) such as vacations, buying a car etc can be planned for.

Do note here that I am nowhere implying that you achieve your long-term goals before investing for short term goals. However, it is wise to plan for long term goals before you plan for short term goals.

What do you mean by goal planning?

Goal planning is simply allocating a part of your active income into investments based on the allocation for each goal.

There are 4 mathematical variables involved here

  1. The timeline of the goal – this is more or less known
  2. The corpus required at the end of the timeline – this is more or less known
  3. The returns your investments will fetch – this is estimated
  4. The amount required to be invested every month to achieve the goal – this is calculated on the basis of 1, 2 and 3 above

Once you have planned for (i.e. allocated periodic investments for the 4 major life goals), feel free to plan for your short-term goals.

What happens if I plan too many short-term goals?

Too many short-term goals would mean large part of your money sitting in debt investments. And that in turn means lower returns, albeit lower risk.

However, the hazard in this is that you will achieve all your short-term goals at the risk of not achieving your long-term goals which are more crucial and inevitable.

Your money is finite and it deserves to be allocated efficiently.

I have myself given up short term goals multiple times in favour of long term goals and it has always worked out. Short term goals have to pass Raju’s filter below:

I have been wanting to buy an apple watch ever since it was launched. Apple is currently on Watch 6 and I still hadn’t got one. Every year, I invested the cost of an apple watch into my long-term financial independence goal. The return on that money is enough to buy an apple watch today without disturbing my corpus. Isn’t that what financial independence truly is? – wanting to do what you wish without worrying about money!

Had I planned a short-term goal of buying an apple watch in 2015, I would just have had an apple watch!

My top priority remains allocating most of my money towards my long-term goal of financial freedom. That is my core portfolio.

We should endeavour to not fall prey to this mindset of Bandya and Gundya, as far as short term consumption goals are concerned.

Because it always leads to this

In summary:

  • Your risk profile is determined by your financial goals, emotional quotient and time spent on researching investments rather than your age.
  • An aggressive risk profile implies higher allocation to equity investments; a conservative risk profile implies higher allocation to debt investments.
  • Define financial goals, it helps in planning your investments better.
  • Longer term financial goals imply higher allocation to equity investments; shorter term financial goals imply higher allocation to debt investments.
  • Plan for inevitable long-term goals. Retirement is a beast that’s tough to tackle!
  • Always favour long-term goals over short-term consumption goals.
  • Your goals and risk profile are an important (but not the only) factor determining your asset allocation.

Don’t ask someone “Is this stock good?”, “Can I buy this stock?”, “Should I sell this stock?”, “Will this stock go up?”, “Whats the target? Stop loss?”.

Instead, ask yourself, “Does this stock fit into my goals?”, if yes, then “what % of my portfolio should it be?”.

Here’s a tip – The next time you get that call giving you stock tips, learn from Babu Bhaiya on how to respond.

Ok, maybe you can exclude the expletives, but you get the point.

In the coming few weeks, we will cover more on the above questions and also on asset allocation which is point 2 of the 5 point investment plan from my earlier blog.

Goals and Risk Profiles I

A while ago, I wrote about how investing is simple. I also laid out a 5 point plan for managing investments. If you haven’t read it, it’s here. A mere 4 minute read.

Let’s build on that and explore point 1 – “Assess your goals and risk profile” in greater detail now.

All of those who have heard these classic dialogues please raise your hand. Or, well, subscribe to the blog so I know you raised your hand.

  1. Your risk profile is determined by your age
  1. Invest 100-your age % of your portfolio in equity
  1. Just started your career? Make sure you invest in small cap equity funds
  1. Nearing retirement? Make sure you shift your investments into fixed deposits
  1. Hello, Devi Prasad ghar pe hai? – Sorry, this has nothing to do with investments! But this blog features Hera Pheri memes and nothing introduces Hera Pheri better than this dialogue. :-p

First, let us examine why goals and risk profiles matter. The key concepts to understand here are

  1. Return – what you make on your investments
  2. Risk – what it takes to make returns

Risk is measured in the form of volatility of returns. Think of it as a speeding car. The faster you drive, the earlier you reach your destination. But is it really that simple? The faster you drive, the more prone you are to a risk of accident.

Debt investments (fixed deposits, bonds, debentures, debt mutual funds etc), generally, give stable returns with lower risk. A fixed (or near fixed) stream of cashflows followed by return of your capital. That being said, debt investments are subject to default too – DHFL bonds, Yes Bank AT 1 bonds, Franklin Templeton Debt MF schemes – we have all seen those collapse. However, these are rare events and with discipline you can avoid these.

Equity investments (stocks, equity mutual funds, ETFs etc), generally, give higher returns but come with increased volatility. Cash flow streams are uncertain as well as differ in amount and frequency. Underlying stock prices also fluctuate – some more violently than others and can result in losing capital. That being said, bond prices also fluctuate with changes in interest but that’s a topic for another day.

For now, debt investments – lower risk, lower return, gives surety of corpus and equity investments – higher risk, higher return, generally gives better returns over long horizons.

So, what determines your risk profile?

Age? This is greatly over-rated and over-emphasized because there is some correlation between age and risk profiles. But not as much as one is made to believe.

A young person wanting to save up for their higher education can definitely not afford to have a higher allocation towards riskier investments in the hope of earning higher returns.

A person close to retirement may have enough capital to pass on to their next generation after having achieved all their personal financial goals. Why shouldn’t they invest more in equities to earn a potentially higher return?

Does Warren Buffet, at his age of 90 years have 10% of his wealth in equity and 90% in debt? His equity exposure is a result of the below mentioned factors rather than his age.

Here’s what should be determining your risk profile

  1. Your future financial goals – the quantum as well as the time horizon towards the goal. The further away your goals are, the more allocation to equity.
  1. Your emotional quotient – can you enjoy a good night’s sleep without worrying about what happens to your portfolio value when you wake up? Happiness is an important factor in investing.
  1. Time spent by you analyzing and researching investments – the more time you spend, the higher your conviction and generally, the higher your risk-taking ability and vice versa

So, what is my risk profile?

It is important to understand that risk profiles can only be estimated. Moreover, risk profiles change with time as your situation in life changes.

Your risk profile can be estimated through a set of questions that address the 3 points raised above. Here is an oversimplified way of estimating your risk profile:

FactorTending towards AggressiveTending towards Conservative
Future financial goalsLargely achievedJust beginning
Emotional quotientCan tolerate drawdowns. In other words
– a fall in the markets makes you go
shopping for stocks without worrying about loss of value of existing portfolio
Can’t tolerate large fluctuations in value of portfolio
Time spent on analyzing and researching investmentsYou love doing thisUgh, who is going to go through all those numbers?
Risk Profiles

The above is only a guide. Of course, there are shades in between Aggressive and Conservative. For eg – moderately aggressive, moderately conservative, neutral etc.

For meme lovers,

Raju is EXTREMELY aggressive. He mortgaged his house and invested in a risky scheme. We all know how that ended. This is an exaggerated example to drive through the concept of an aggressive risk profile.

Shyam is probably neutral, he asks questions about investments and risks, doesn’t like fluctuations in his wealth.

Babu Bhaiya is at the other end of the spectrum. He is being EXTREMELY conservative. At least in this meme.

What does a risk profile mean?

Your risk profile should determine your asset allocation. Here’s a quick table.

Risk ProfileAllocation towards debtAllocation towards equity
Tending towards aggressiveLessMore
Tending towards conservativeMoreLess
Risk Profiles and Allocations

Notice how I say less and more and not 0% or 100%. Also, your risk profile is not the only determinant of your asset allocation. Market factors such as valuation, earnings etc also matter but thats a topic for another day.

And if you believe in a proof of the pudding approach, here’s a shortcut – In the previous market meltdowns, how did you act? If you exited, your risk appetite is low. If you added to your portfolio, your risk appetite is high.

Ok, I can estimate my risk profile now but what are financial goals? – Let’s explore that in part 2 of this blog, coming soon.

Is investing really that complex? Is anything really that complex? Is rocket science even rocket science?

It was December, 2017. My cousin, Dr Amit Prabhu, called up and said “I am coming to Mumbai for a week, will stay with you. Can you arrange for 4 dozen eggs, 4 kg of paneer from a good quality source and 1.5 kg of plain peanuts?” I replied “Of course!” while being perplexed about the oddity of his question.

When he came, he looked different! My 40 year old cousin looked like he was in his 20s. Jawline, defined biceps, wearing an M sized shirt. As if straight out of college. I punched him in the stomach only to have his washboard abs block my fist. He and I had idolized Hrithik Roshan, Salman Khan et al in our teenage years. Pumped iron senselessly at gyms, compared our bicep sizes, bought body hugging clothing, you know what a 90s kid went through! But never saw much progress for over a decade. Eventually, the grapes became sour and we concluded at that time “It’s all steroids. We would rather not have a beach bod if that’s what it takes.” And now at 40, he seemed to have cracked the code.

He gave me a 2 hour talk on how he got here. “Its simple” he said. An online community Fittr (then called Squats) helped him learn understand nutrition. All he did was:

  1. Set his fitness goals and accordingly set a calorie intake
  2. Monitored his total calorie intake
  3. Within that total calorie intake, he had set a certain proportion of carbs, proteins and fats
  4. Exercised moderately (and not senselessly like earlier!) but regularly
  5. Been disciplined on all 3 points above

And that’s it. Those six pack abs which eluded him for a decade showed up in 4 months with nothing more than the steps cited above.

The oddity of his eggs, paneer and peanuts question now was explained! That related to point no 2. More on that later.

This was a time when I was grappling with being overweight. Along with that came blood pressure medicines and statins for controlling cholesterol. Taking copious notes, I came up with my own customized 5 point plan. Took me 8 months to shed 18 kgs, stop my BP medication and bring my cholesterol to a healthy level.

So how is all this related to investing you ask?

Coincidentally at that time, I was also grappling with poor portfolio returns. Unresearched fun fact – Stress levels and health are inversely correlated with portfolio returns! What would happen if I applied these same principles to investing?

Think of it…

Me and my cousin focused on the gym and all things sundry, ignored eating right and didn’t see results

Have crash diets, meal replacements, protein supplements and long hours at the gym made anyone healthy? People may have lost weight, built some muscle, yes. But most gained back the lost weight soon enough.

Have share tips made anyone wealthy? People may have made gains. But most would have lost that money on the next tip.

We tend to focus on tips, short term plays – buy XYZ stock at 100, sell at 120, stop loss 90. That approach doesn’t create wealth. You are better off at a poker table – at least you enjoy the game! Can you be consistently right about XYZ hitting 20% every time you buy? If yes, skip reading further :-p

What’s the lesson here? Focus on 1. What matters and 2. what is sustainable

Focus on eating right. Not on short-term diets. Focus on regular exercise and break-up of diet i.e. allocation of calories between carbs, protein and fat.

Focus on investing right. Not on which stock is going up. Focus on asset allocation between debt, equity and gold.

We had cycles of being serious and being casual about our goal of six pack abs

In bull runs, the markets seem attractive don’t they? Your excitement about markets goes up. In bear runs, you blame the stock market and call it a gambler’s den. Sounds familiar?

Be a consistently active investor or be a consistently passive investor. Don’t be active when markets are rising and passive when markets are falling.

Was it really simple to get six pack abs?

5 point plan! That’s simple. Adhering to that 5 point plan? Now that’s the tough part. It’s easy to give up to temptations. Now do you understand my cousin’s obsession about eating right – both what he eats and how much he eats? And also he follows the same routine even while traveling.

One core life principle is – discipline trumps intellect. And it’s true about nutrition and more so about investing. Be disciplined about where you invest and how much you invest.

In the coming few weeks, we will delve deeper into this from an investing perspective.

What’s the 5 point plan for managing investments?

You can guess this by now but let me spell it out anyway.

  1. Assess your goals and risk profile
  2. Based on 1, form an asset allocation
  3. Within that asset allocation, pick the right investments. ‘Right’ here points to cost efficient and quality investments in each asset category viz. debt, equity and gold – more on this later
  4. Rebalance asset allocation at regular intervals (and not very often!)
  5. Be disciplined on all 4 points above

If you don’t believe me, ask Master Shifu!

Image credit: DreamWorks Animation (Universal Pictures)

Everything is simple. We end up complicating it to prove our intellect to ourselves. There are no quick results ever. If there are, they won’t last. Slow, boring but consistent is an approach that should be applied to everything in life.

And if that’s not enough proof, here’s Po looking at the dragon scroll reflecting back “there’s no secret, it’s you”.

Image credit: DreamWorks Animation (Universal Pictures)

And before you ask – No, I do not have six pack abs but I am fit. I am no billionaire investor but I have managed my investments well.

Some day……..I will be a billionaire with six pack abs.