Risk: An underrated word in today’s investment landscape

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

It’s also important to recognize that answering a set of questions might not fully capture an investor’s risk tolerance. True understanding develops over time, particularly when the advisor and the 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 upswings is essential.

For instance, investors who were conservative during the covid-19 crisis have now turned aggressive, seeking maximum equity exposure. If an advisor suggests otherwise, taking into account their goals and risk profile, these investors might bypass the advice and opt for direct equity exposure through risky products like portfolio management services (PMS), alternative investment funds (AIFs), 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 comprehend the concept of risk. Armed with information from free tools and a plethora of online resources, they often feel confident navigating the market’s challenges—sometimes with misplaced confidence. Many trade in derivatives without fully appreciating the potential for loss.

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

This phenomenon can be attributed to the “recency effect”, a cognitive bias where recent information is given more weight than past experiences. In a rising market like today’s, the possibility of a downturn seems remote to them, leading to complacency in risk management and an overemphasis on risky investments. Conversely, during a market decline, the fear of loss drives investors toward safer options, often ignoring the inherent risks in those choices as well.

Such one-sided approaches rarely lead to long-term success. This is why investment advisors who practice financial planning continually nudge their clients toward a process-oriented and disciplined approach to investing.

These are challenging times for true advisors. Their role extends beyond merely helping clients grow wealth; they are also guardians of their clients’ financial well-being, working to prevent significant losses. Advisors often recommend rebalancing portfolios—selling equities to buy defensive assets—but investors may resist, reluctant to reduce their equity exposure while expecting double-digit returns. Some may even ignore this advice, venturing into direct equity investments through brokers or platforms like Smallcases.

Risk profiling

Risk profiling is akin to a blood pressure check before prescribing medication, and asset allocation is like maintaining a balanced diet. If you have high blood pressure and don’t follow an appropriate diet, the consequences may not be immediately apparent, but long-term damage to your organs is likely. Similarly, balance is key to a healthy financial life.

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

Never overextend in volatile asset classes to reach your goals faster. While this strategy may occasionally yield success, it is not sustainable and could lead to significant long-term damage to your wealth.

Moreover, it’s essential to recognize that risk is not a static concept—it evolves with time, market conditions, and personal circumstances. What may seem like a tolerable risk today could become overwhelming tomorrow, especially as life events such as retirement, health issues, or unexpected expenses come into play. Therefore, regular reviews and adjustments of one’s risk profile and asset allocation are necessary to ensure they align with changing realities.

Investors often underestimate the value of professional advice, especially in a bull market where everyone seems to be making money. However, it’s during these times of exuberance that the seeds of future losses are often sown. A professional advisor’s role is not just to guide through the complexities of investment 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 it performs in good times but how it withstands the bad. This is where understanding and respecting risk comes into play. Those who dismiss risk as an unnecessary consideration may find themselves unprepared when the market inevitably turns.

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

Manikaran Singal is the principal officer at Good Moneying Wealth Planners Pvt. Ltd, a Sebi-registered investment advisor.