For financial planners, it is important that we keep learning new things. But it is also important that, we validate what we have learned in the past as we move forward. Recently, I realized that something written on all the financial planning books published 20 years ago may not be relevant to the current generation. It was written during the time when financial wizards assumed common people come from “know nothing” background (they didn’t say it out loud). But we blindly follow the same instructions without thinking for ourselves.

What is risk assessment?

Financial planners (including me in the past) ask investors to fill in a predefined questionnaire of 10 or 20 questions. After they answer, the tool will calculate the risk appetite and the risk tolerance which will be used to determine the investor’s asset allocation. Like for example, if the tool says an investor has high risk tolerance, we may decide up to 70:30 Equity:Debt ratio and reduce the equity ratio if the tolerance is lower.

That’s perfect. So what’s wrong?

There is nothing wrong with the tool itself but as planners we never think, what was the mental state of the investor when he/she was filling the questionnaire? There’s the problem.

If you ask me, an investor who wakes up on a lazy Sunday morning, fills in the questions taking a cup of coffee in his/her hand will take lower risk than a person who has gotten back home after driving in a crazy traffic for 3 hours.

A person who has gone through a horrific tragedy in the family or has recently gone through the divorce will have the higher risk capacity than a person who is just going through a daily routine.

A person who is aware that the market is on an upward trend will be ready to take more unnecessary risk than a person who has no idea about what’s going on in the market. Think of it. If you are aware of current market conditions, you would fill in the questionnaire in such a way that the tool will give you the high-risk tolerance. In theory, you don’t mind losing 30% of your invested money because you think you are confident of keeping the money on the table for decades. You will blindly believe that India will be great again. All the positivity in the stock market and with all your friends investing, you think you can never go wrong. In reality, the fast access to easy information has made “know nothing at all” crowd disappear. Most people are smart enough to manipulate the results to choose those answers which will make them high- risk investors. And, so called financial advisers believe in the tool results and allocate high equity percentage during the asset allocation. Investors get what they want, and advisers get more commissions. Win-win for all. Isn’t it? This is what I call a big load of bull crap.

Then how to decide on asset allocation?

After much deliberation, I found a solution that makes some sense to me. Let’s imagine that we are fully invested in Equity. What is the worst that could happen when we retire? A market crash like 2008 or worse!! The very fundamental of investing is to keep the money invested when the market is down. It brings in a dilemma what to do if the market crashes on the year of our retirement.

Say, if you have enough money tucked away in safe instruments (like debt funds) with which you can lead a decent life for 5-7 years, would you be worried too much about the market crash? May be NO. It reduces stress because you already have an answer for where your money will come from for next couple of years. You can afford to keep the money invested in market which has the tendency to recover in 5-7 years.

In simple words, if you built enough money that can sustain your lifestyle for about 5-7 years of your retirement, you are good to go. Projecting backwards using a simple formula will give you the debt portion of investment that you would need to invest considering your retirement expenses.

In essence, the debt part of our asset allocation depends on our current expenses rather than risk taking capacity. As and when our expenses increase that may continue during our retirement, we would need to rebalance our asset allocation. In my opinion, filling in a questionnaire and giving ourselves a false sense of risk-taking capacity is just useless. But there are situations which cannot be predicted or assessed but can put the plan at risk. Something like a war or an extreme natural catastrophe. It may take decades for a country to recover economically when such things happen. All we can do is to live frugally to make best out of what we got.