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The textbook answer, according to many "financial planners", is to first determine your risk appetite and then design a portfolio of funds consisting of a proportion in equities and bonds depending on the results.
In a nutshell:
To determine the risk appetite, a standard questionnaire is normally used which covers areas like age, investment horizon, real life choices, probability pay-off tolerance, etc. Then a score is computed showing if you are risk adverse, balanced, conservative or aggressive.
Subsequently, a portfolio consisting of 70% bonds - 30% equity for adverse; 50% bonds - 50% equity for balanced; 30% bonds - 70% equity for conservative; and 100% equity for aggressive.
In my opinion, this approach does not make any sense at all.
Firstly, risk taking is affected by so many factors as highlighted in my earlier article of limitations of rationale thinking. Therefore, how accurate are these questionnaires in measuring ones risk. And as illustrated later, the results mostly do not reflect one's approach towards risk management.
Secondly, I believe everyone is inherently loss adverse. Regardless if you are risk adverse or aggressive, all rationale people do not like to lose money. Hence, if we are all the same, profiling our "risk appetite" should not determine how we should invest.
Thirdly, I believe that diversifying into the "balanced" portfolios is actually doing more harm. Normally, when bond outperforms, equity under performs and vice-versa, they are negatively correlated. As a result, investing like that increases your risk with no significant improvement in returns.
So, how then should I invest? Read more...[caption id="attachment_3664" align="alignright" width="150" caption="Photo by kevindooley"][/caption]
The textbook answer, according to many "financial planners", is to first determine your risk appetite and then design a portfolio of funds consisting of a proportion in equities and bonds depending on the results.
In a nutshell:
To determine the risk appetite, a standard questionnaire is normally used which covers areas like age, investment horizon, real life choices, probability pay-off tolerance, etc. Then a score is computed showing if you are risk adverse, balanced, conservative or aggressive.
Subsequently, a portfolio consisting of 70% bonds - 30% equity for adverse; 50% bonds - 50% equity for balanced; 30% bonds - 70% equity for conservative; and 100% equity for aggressive.
In my opinion, this approach does not make any sense at all.
Firstly, risk taking is affected by so many factors as highlighted in my earlier article of limitations of rationale thinking. Therefore, how accurate are these questionnaires in measuring ones risk. And as illustrated later, the results mostly do not reflect one's approach towards risk management.
Secondly, I believe everyone is inherently loss adverse. Regardless if you are risk adverse or aggressive, all rationale people do not like to lose money. Hence, if we are all the same, profiling our "risk appetite" should not determine how we should invest.
Thirdly, I believe that diversifying into the "balanced" portfolios is actually doing more harm. Normally, when bond outperforms, equity under performs and vice-versa, they are negatively correlated. As a result, investing like that increases your risk with no significant improvement in returns.
So, how then should I invest? Read more...
[/caption]
The textbook answer, according to many "financial planners", is to first determine your risk appetite and then design a portfolio of funds consisting of a proportion in equities and bonds depending on the results.
In a nutshell:
To determine the risk appetite, a standard questionnaire is normally used which covers areas like age, investment horizon, real life choices, probability pay-off tolerance, etc. Then a score is computed showing if you are risk adverse, balanced, conservative or aggressive.
Subsequently, a portfolio consisting of 70% bonds - 30% equity for adverse; 50% bonds - 50% equity for balanced; 30% bonds - 70% equity for conservative; and 100% equity for aggressive.
In my opinion, this approach does not make any sense at all.
Firstly, risk taking is affected by so many factors as highlighted in my earlier article of limitations of rationale thinking. Therefore, how accurate are these questionnaires in measuring ones risk. And as illustrated later, the results mostly do not reflect one's approach towards risk management.
Secondly, I believe everyone is inherently loss adverse. Regardless if you are risk adverse or aggressive, all rationale people do not like to lose money. Hence, if we are all the same, profiling our "risk appetite" should not determine how we should invest.
Thirdly, I believe that diversifying into the "balanced" portfolios is actually doing more harm. Normally, when bond outperforms, equity under performs and vice-versa, they are negatively correlated. As a result, investing like that increases your risk with no significant improvement in returns.
So, how then should I invest? Read more...
