When risk reduces in the natural course or is perceived to reduce, we get into the mode of assuming more risks, while when risks are high and we take steps to mitigate these risks, the reduced risk again compels us to take on more risks, which is risk compensation. Learn more strategies on risks and and investing from this book excerpt
Malvika had called me the other day to see if she could come over that day itself, towards the evening. Since it was not possible for me that day I suggested that we meet three days later. And today was that day. She may be coming any moment now. I was going to talk about a few other areas that may pique her curiosity and interest.
I had already talked about risk earlier. I wanted to give her a download on many other areas today. I wanted to talk to her about consumer behaviour, an essential area for all of us to know. It is a critical area that needs understanding to ensure compliance, and ultimately get good outcomes.
Risk compensation, additional risk assumption, and risk misperception when the risks come down are some rather puzzling behaviours which we see all the time. Risk mitigation is an important part of ensuring a steady life. It is important to cushion against shocks, in all areas of life. However, whenever a risk-mitigation measure is taken, we have also found that people overreach and end up taking more risks. They get into the risk-compensation mode.
For instance, it has been found that those wearing helmets while riding bikes tend to be rougher riders as compared to others. That is because those wearing helmets tend to feel safer and are willing to take more risks! Seat belts similarly make the drivers speed and take tighter turns.
So, risk-mitigation tools are not always as effective as they should be when it comes to outcomes. And that is the paradox. It works like this in many areas of life.
The other thing that happens when the risk in one area comes down for a person is that they don’t seem to be happy there. They invariably assume more risks. Additional risk assumption hence is the other important consumer behavioural paradox.
Also, a lot of times, we do not perceive the risks that are very much there. That is risk misperception.
We will be dealing with these three paradoxes as they apply in real life.
Parents want to do everything for their children, give them the best and cushion them from the harsh realities of life. This is a classic risk-mitigation mechanism. But what really happens? They accompany their children everywhere, robbing children of initiative and inhibiting their learning by doing everything for them. The children operate in an environment where they pretty much get everything, without so much as lifting a finger.
Their social interaction skills are stunted as they are exposed to a carefully curated audience! They are not in touch with reality; the millennials return for more money lessons if god was your financial planner and tend to develop elitist attitudes that work against them in their interactions with the real world.
The children get used to fancy schools, air-conditioned classrooms, private tuitions, access to pricey learning aids, fancy toys, branded clothes, etc. Many children do capitalise on the advantages conferred on them, score well and rise up. But does this prepare them for the real world? Hardly.
They are in fact, unfit to operate in the real world of grime and hard work. They want sanitised environments like their parents provided them. But that is nowhere to be found. The outcome is that the children find themselves unsuited in most areas of life—work, relationships, money, etc.
Parents’ risk mitigation behaviour for would make the child maladjusted and creates problems for their wards in the future.
When things are going well, people tend to do certain things that jeopardises everything they have. Is it boredom, hubris, search for challenges—we don’t know.
Here they may be assuming unwanted risks, when the risks go down.
We have seen people at the height of their career taking unwarranted risks. For instance, they gamble by moving to another firm even though they are doing fine, are well-regarded and rewarded in the company they work. Some want to push their luck by embarking on an entrepreneurial venture with huge risks and uncertain payoffs.
There are others who indulge in an ill-fated fling with a colleague that can jeopardise their careers.
It is almost as if they do not want to enjoy the good life that they have been endowed with!
A similar thing happens with money. When a person invests somewhere and makes money a few times, the person gets a feeling of invincibility and their perception of risk becomes skewed. This is risk misperception. This is what happens in a rising market where someone invests in equity and makes money. They tend to think that they are the latest rodeo riders in the market and put in increasing amounts of money, only to find themselves thrown to the ground, at some point in the future.
Apart from this, people also indulge in some money maximising tactics and invest aggressively, without considering their risk profile. This is a combination of greed, risk misperception and unnecessary risk assumption.
They decide for instance that they are through with the middle-class routine of investing in mutual funds and now want to invest in PMS, structured products, alternate investment funds (AIF), private equity, and so on.
Most people don’t understand the risk–rewards inherent in their investments and simply invest based on returns it has given in the past. This adds tremendous risks in the portfolio and is an example of unnecessary risk assumption.
Again, when things are going well, the heavens seem to be smiling, and one is well set to achieve their goals, people feel that urge to stretch things a bit. They want to achieve certain stretched goals, now that the going is fine. This is a voluntary risk assumption. A high-end car, grand home in a tony neighbourhood, world tours, lifestyle upgrade, etc. are some of those. There is nothing wrong with these new goals as people earn to enjoy. But some of these increase the overall risk quite significantly.
For instance, an expensive home bought on loan increases costs significantly and reduces headroom for manoeuvre. If the millennials return for more money lessons if god was your financial planner loan is so high that the couple needs to work for a long time, they lose their flexibility. Also, today there is the possibility of a job loss for any number of reasons, which can land them in a jam.
Then, there is this goal of educating kids abroad, which is quite common these days. The only issue is that this is by far the costliest exercise a parent can undertake. Children’s education is moreover an emotive issue and parents want to fund the whole binge, costing crores.
These things individually may not upset the overall life trajectory. But a few of these together can exert tremendous financial stress.
When people are on medication, and things start looking up, people loosen up a bit and start going freely on starches and fats! The effect of this is not immediately evident. But it does have a delayed impact.
This is the same effect as when a person wears a helmet, he rides more rashly than he used to. Again, an example of risk compensation.
To summarise, when risk reduces in the natural course or is perceived to reduce, we get into the mode of assuming more risks. When risks are high and we take steps to mitigate these risks, the reduced risk again compels us to take on more risks, which is risk compensation. At certain points in life, the risks reduce and things may be going smoothly. For some people, the decreased risk makes them take up more risk, which is an example of risk assumption.
A person wearing a helmet riding more rashly is risk compensating. When a person throws up a job when everything is going well, they are assuming unwanted risks.
Many times, we perceive less risk than there is. This is risk misperception due to which we end up taking unwanted risks. This happens quite naturally in many facets of life. It is for us to recognise and avoid taking unwanted risks. Managing risks well is a fundamental part of wellness—whether it is with money, health, work or in other areas.
I thought someone was at the door and surmised that it must be Malvika. Nor was I mistaken. But in thinking that it would only be Malvika who came, I certainly was mistaken. There were four people with Malvika. I immediately recognised Urvi and Priya.
There was another girl and a boy, who were new faces for me! Malvika sheepishly came into the cabin and told me that she had brought with her four of her friends this time. She said she was very sorry to impose upon my kindness and magnanimity but could do nothing as, apparently, she gave such a rousing account of my session last time that her friends certainly wanted to be there.
I told her that there was no problem. I told her that at this rate I would be conducting college classes in my office! I saw that her face had become clouded after this comment, and I realised that I might have been a bit offensive.
I told her that I was just joking and would be happy to have them here. This instantly cheered up Malvika. She waved her friends into the cabin and introduced the two I did not know. The girl Dipanjana and the boy Vignesh. With the introductions out of the way, I was ready to start.
I asked whether there was anything specific that they wanted to know. No one answered. I looked at Malvika. After a short pause, she said that maybe I could throw some light on the systematic withdrawal option of a debt fund. She said she had read the millennials return for more money lessons if god was your financial planner up about this since the last time we met. She said she came across this concept when she was reading about debt funds and how they can be used to set up a stable income, in a tax-efficient manner.
I looked around and wanted to see if this was okay with them. Their faces were mostly inscrutable. I then actually asked whether I could take this subject up for discussion. They agreed with the plan and so I started.
‘Systematic withdrawal is an option that can be used to good effect in a debt fund to set up an income. Systematic withdrawal is redemption of a certain amount from the debt fund in which one has invested, at a predetermined frequency.
‘You might wonder what is so hot about redeeming from a fund in which one has invested in? But it does have its merits.
‘For one, the tax treatment, in this case, is of capital gains, and hence the effective returns are higher. Also, one can set up the amount required as regular income, which can be done for the period of one’s choice.
‘Hence, this would be a good tool in the hands of someone who is looking to set up a regular income. Retired people are the ones who need regular income, and this could be a handy tool for them.
‘Most retired people dip into their savings accounts or turn to bank fixed deposits to meet their regular income needs. At a time when interest rates are down, turning to bank FDs can expose a person to a significant risk called reinvestment risk.
‘When the money matures, if the prevalent interest rates are down, and one needs to invest at those lower rates, it is a risk, right? This is reinvestment risk.
Suresh Sadagopan is Founder, Ladder7 Financial Advisories