“How do I start my financial planning?”
“Well, list all the financial goals and create a plan for meeting those goals, and yes, if you remember then take a risk tolerance quiz.”
This is the common approach to financial planning, we see. My point is risk tolerance assessment is often considered a formality rather than the primary component of financial planning. In this article I will try to explore why that could be an erroneous notion and the mechanical approach to financial planning based on expected returns may be creating serious problems for investors.
Expected Returns are Theoretical
This is obvious, but while creating investment plans people forget that. The expected return of a portfolio is calculated based on past returns and it must be understood that the actual return of your portfolio may (most likely will) vary drastically from your expected return and yes even after periodic rebalancing. A precise spreadsheet about future returns is often a representation of a false sense of security.
My point is that because the expected returns are very unreliable, planning based on those numbers is unreliable to the least. The issue is not that the calculations are not precise, but that precise number creates a false sense that our financial future is completely secure once we are done with the planning.
Start with Risk
The point of financial planning is to create a portfolio for your financial goals. Now, a portfolio is better described as a set of risk exposures than expected returns. We have much higher control over the risk exposures we take over the return of the portfolio.
What About Goal Planning?
In light of the above discussion, we can say it is practically impossible to plan precisely all our financial goals. The best we can do is to prioritize them. As I already mentioned, a precise spreadsheet is a sign of a false sense of security.
Here, an expected return based on past returns can be useful, but only for indicative purposes, i.e. to help us understand which goals are attainable, which are a stretch, and which are unlikely to be attained but we cannot manage those goals. The only thing we can manage is our risk exposures.
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So, What is the Alternative?
I propose starting the whole process with an analysis of risk tolerance and defining detailed risk exposure capacity. By detailed, I mean defining not only the amount of risk but also the type of risks one is capable and willing to take.
The biggest misconception in this context is that risk is monolithic and can be described by a single parameter. Unlike return from a portfolio, risk has many facets. Market risk, credit risk, interest rate risk, liquidity risk, and inflation risk are some examples.
Each investor has a different capacity and willingness to take different kinds of risks. It is imperative to define with significant clarity what kind of risks the investor is capable and willing to take and what kind of risk is simply not acceptable.
For example, an investor may be willing to handle fluctuation in the portfolio value, but significantly sensitive to liquidity risk, i.e. a liquidity crunch may create havoc in the life of the investment. Another investor may not have a legal understanding to handle credit risk.
We often deal with such complexity in defining risk with vague simplification – conservative, aggressive, etc. which are neither measurable nor useful. I rather suggest defining risk exposure requirements in concrete numbers – such as auto x% volatility, up to this much Macaulay Duration, at least y% of the portfolio in liquid assets, etc.
The portfolio an investor builds should be based on the risk exposures she is willing and capable to take. Our obsession with returns leads us to a situation where we try to define what we cannot control, forgetting to define what we can i.e. our risk exposures.
What is the Problem with the Expected Return-Based Approach?
1. A false Sense of Comfort
The mechanical approach leaves us with a precise plan and precision is the biggest fault of the plan. Precision about future forecasting is useless. Also, it creates an idea that a financial plan is static, whereas the assumptions on which the plan is based are all dynamic and ill-defined.
For example, we use past average inflation figures to calculate the increase in future expenses. Past inflation figures, poorly represent the future possible figures, especially in a developing country like India, where the currency is significantly unstable.
2. Focusing on what we cannot control
As mentioned before, we have very limited control over returns – the sooner investors understand that the better. Past returns are again, poor representatives of future returns, and that should not be the basis of life decisions. We should base our financial planning on what we can control, i.e. our risk exposures.
3. Ignoring what we can control
How many retail investors actually understand the risks their portfolio is exposing them to? Not many. Risk assessment is often dealt with as a formality and that is dangerous. How many people understand that they expose themselves to both liquidity and inflation risk by investing in fixed deposits?
These risks have real implications in our lives and often we do not define and manage them sufficiently while creating our portfolio when we can actually define and manage risk exposures much better than the returns.
The purpose of this article is not to promote risk avoidance, but to encourage detailed risk assessment and risk management. What I am proposing here is clearly defining the amount and types of risks the investor is capable and willing to take, basing the portfolio on the defined risk exposures, evaluating the portfolio based on defined risk exposures, and doing appropriate rebalancing and prioritizing the financial goals instead of making a precise (and often misleading) plan to achieve all the goals.