It is a truism that risk and reward are correlated and that you need to take bigger risks if you want greater rewards. However, this thinking is flawed, because most people never bother to think about what risk and reward mean to them as individuals! The fact is that all of us are different, and we have varied goals, desires, needs and wants, which evolve over time.
One size cannot fit all, and we need to think about applying the risk reward equation to our personal situation. If we fail to do so, we will end up burning our fingers, and end up taking on too much risk for very little reward!
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Thus, many share market investors confuse risk with volatility, and this is wrong, and leads them to make many errors. Why should you care if the market dips, as long as you don’t need to sell your shares at that time? Paper profits and paper losses are meaningless scorecards, and you need to learn to tune out the noise.
Most wealth managers will sell their ability to outperform the index (alpha) as a measure of their worth. However, for you as an individual, alpha may not be the best metric to judge rewards. In fact, this often causes a lot of angst, because you start comparing your manager’s performance with those of others, and this tempts you to switch to the fund which has provided the best returns over the last few months. This is how mutual funds will sell their schemes, but is often the best way to lose your wealth, because of the phenomenon of regression to the mean.
For many investors, the most valuable benefit of a good wealth manager is peace of mind. Finding someone who is honest and competent will allow you to sleep well at night, because he will not try to chase outsize risk and reward in a futile quest to beat the competition. He will provide slow and steady returns by sticking to an investing style which works well for him, rather than try to follow the most fashionable fad – a tactic which leads to disaster. Your focus should always be on return of capital, rather than on just return on capital. Chasing yield can cause sleepless nights when the market tanks, and this can be a high price to pay!
[This post by Dr. Aniruddha Malpani first appeared on LinkedIn and has been reproduced with permission.]