Investment decisions are about one’s ability to face future uncertainties

If we reconcile the wisdom from multiple sources, on one hand it requires us to generate returns and increase our wealth. On the other hand, it also cautions us against excessive risk taking. But how do we measure risk, and calibrate our need for wealth enhancement? The latter is relatively simple. Take a deep breath and assess your financial needs

Shivam: “Nishchit Hai Kuchh Bhi Nahi, Sambhavna Ka Sab Khel, Tathya Parakh, Smbhaavna Se Lakshya Ka Kar Lo Mel”

Translated into English, it implies: You cannot be sure of anything; either it’s not or is probable. Assess with facts in hand, the probability of being profitable.

Financial markets would not exist if asset prices (and returns from investing in them) came with perfect certainty. Our pursuit of certain outcomes is deeply rooted in culture.

For example, Chanakya states in Arthashastra: “Yo Dhruvani Parityajya Adhruvam Parishevte . Dhruvani Tasya Nshyanti chadhruvam Nashtamev Hi.” (One who gives up certain outcomes against the uncertain ones loses what s/he has. What they do not have is not theirs anyhow.)

This wisdom became conventional over time and may certainly have been apt in the context of those times. However, this has also rendered many of us excessively risk averse. Instant gratification, a basic human instinct would imply consuming with content all one has. But, investment calls for delaying the consumption with a hope to consume more in the future.

Is not that pure greed? In an increasingly complex world, the wealth one currently holds may be inadequate to fulfill needs of the future. For example, a young couple may need to plan for its future as the responsibilities will rise along with an increase in the household size. From children’s education to one’s own retirement and healthcare expenses, all require one to work hard and conserve for the future.

However, “conserving” for the future must not mislead one into being financially conservative. Conserving for the future implies prudent investment decisions, calculated risk taking, and investing wisely. Hence, conserving for the future is expecting returns on your wealth over a period of time. Over time, not only your wealth must increase, but the same must also be espoused with higher purchasing power. This greed for high returns may, ironically, be good for society. Robert Pagliarini, a wealth manager, reasons “…The problem is not that we're too greedy, it's that we're not greedy enough!”

However, reckless risk-taking is undesirable. Warren Buffet criticizes some Wall Street managers: “…To make money they didn’t have and didn’t need, they risked what they did have and did need.”

If we reconcile the wisdom from multiple sources, on one hand it requires us to generate returns and increase our wealth. On the other hand, it also cautions us against excessive risk taking.

But how do we measure risk, and calibrate our need for wealth enhancement?

The latter is relatively simple. Take a deep breath and assess your financial needs. Are you planning on buying a home in the future? How long will it take for your kids to go to college? Are you concerned about healthcare expenses in the family? How imminent are they? Is your retirement plan adequate? All these questions lead to a broadly quantifiable estimate of how much growth in wealth you must expect.

The next pertinent question is: How much returns must your current wealth and future incomes generate to get you there? Investment decisions, inherently, are about one’s ability to face uncertainties about the future. The higher the risk you take, higher will be the returns. But as we noted earlier, are these returns predictable?

Financial theory argues that asset prices are random. If so, would not any endeavor of investment be purely a game of lottery, a gamble? Not really! Random is not the same as haphazard. A haphazard phenomenon is too irregular to be understood. On the other hand, if something is random, it still follows a pattern. Mathematics provides tools to comprehend patterns using the theory of probability. One needs to be adequately informed about the outcome patterns before investing. With an adequate investment timespan, one can achieve a higher degree of predictability in returns. One can achieve this predictability also by adequately diversifying the investment into numerous assets.

For example, Nifty50 is risky in the short run, with a 25% chance of losing money, if the investment is for a year. However, over a 10-year investment horizon, Nifty50 has never generated negative returns. In fact, there are 80% chances that one will generate an annualized return exceeding 10%. However, depending on the risk of an asset, the predictability patterns may vary. Instruments such as mutual funds may offer a high degree of diversification.

An informed investor must first assess the future needs and select a matching investment from a suite of possibilities that can potentially generate such returns. The trick is to minimize risk for the targeted maturity of an investment given their expected return.

(The writer is Senior Vice-President, SBI Funds Management Limited).

(Prof Prashant Das, Associate Professor: Finance & Accounting, IIM Ahmedabad, has translated from Hindi)

“Nishchit Hai Kuchh Bhi Nahi, Sambhavna Ka Sab Khel, Tathya Parakh, Smbhaavna Se Lakshya Ka Kar Lo Mel”

Translated into English, it implies: You cannot be sure of anything; either it’s not or is probable. Assess with facts in hand, the probability of being profitable.

Financial markets would not exist if asset prices (and returns from investing in them) came with perfect certainty. Our pursuit of certain outcomes is deeply rooted in culture.

For example, Chanakya states in Arthashastra: “Yo Dhruvani Parityajya Adhruvam Parishevte . Dhruvani Tasya Nshyanti chadhruvam Nashtamev Hi.” (One who gives up certain outcomes against the uncertain ones loses what s/he has. What they do not have is not theirs anyhow.)

This wisdom became conventional over time and may certainly have been apt in the context of those times. However, this has also rendered many of us excessively risk averse. Instant gratification, a basic human instinct would imply consuming with content all one has. But, investment calls for delaying the consumption with a hope to consume more in the future.

Is not that pure greed? In an increasingly complex world, the wealth one currently holds may be inadequate to fulfill needs of the future. For example, a young couple may need to plan for its future as the responsibilities will rise along with an increase in the household size. From children’s education to one’s own retirement and healthcare expenses, all require one to work hard and conserve for the future.

However, “conserving” for the future must not mislead one into being financially conservative. Conserving for the future implies prudent investment decisions, calculated risk taking, and investing wisely. Hence, conserving for the future is expecting returns on your wealth over a period of time. Over time, not only your wealth must increase, but the same must also be espoused with higher purchasing power. This greed for high returns may, ironically, be good for society. Robert Pagliarini, a wealth manager, reasons “…The problem is not that we're too greedy, it's that we're not greedy enough!”

However, reckless risk-taking is undesirable. Warren Buffet criticizes some Wall Street managers: “…To make money they didn’t have and didn’t need, they risked what they did have and did need.”

If we reconcile the wisdom from multiple sources, on one hand it requires us to generate returns and increase our wealth. On the other hand, it also cautions us against excessive risk taking.

But how do we measure risk, and calibrate our need for wealth enhancement?

The latter is relatively simple. Take a deep breath and assess your financial needs. Are you planning on buying a home in the future? How long will it take for your kids to go to college? Are you concerned about healthcare expenses in the family? How imminent are they? Is your retirement plan adequate? All these questions lead to a broadly quantifiable estimate of how much growth in wealth you must expect.

The next pertinent question is: How much returns must your current wealth and future incomes generate to get you there? Investment decisions, inherently, are about one’s ability to face uncertainties about the future. The higher the risk you take, higher will be the returns. But as we noted earlier, are these returns predictable?

Financial theory argues that asset prices are random. If so, would not any endeavor of investment be purely a game of lottery, a gamble? Not really! Random is not the same as haphazard. A haphazard phenomenon is too irregular to be understood. On the other hand, if something is random, it still follows a pattern. Mathematics provides tools to comprehend patterns using the theory of probability. One needs to be adequately informed about the outcome patterns before investing. With an adequate investment timespan, one can achieve a higher degree of predictability in returns. One can achieve this predictability also by adequately diversifying the investment into numerous assets.

For example, Nifty50 is risky in the short run, with a 25% chance of losing money, if the investment is for a year. However, over a 10-year investment horizon, Nifty50 has never generated negative returns. In fact, there are 80% chances that one will generate an annualized return exceeding 10%. However, depending on the risk of an asset, the predictability patterns may vary. Instruments such as mutual funds may offer a high degree of diversification.

An informed investor must first assess the future needs and select a matching investment from a suite of possibilities that can potentially generate such returns. The trick is to minimize risk for the targeted maturity of an investment given their expected return.

(The writer is Senior Vice-President, SBI Funds Management Limited).

(Prof Prashant Das, Associate Professor: Finance & Accounting, IIM Ahmedabad, has translated from Hindi)