My friend, Shiva Garru of Hyderabad, told me a story that is really difficult to believe. It can be amusing for the readers but sad for the participant.
The story
Shiva's father-in-law had invested money in fixed deposits and lost money. On the other hand, his father had put a lot of money in equity shares; he also lost money. So Shiva concluded that 'investing' is risky. The deposits, by the way, were in the Nagarjuna Group and the equity investment was in Satyam.
I explained to him that 'not investing' is equally risky; remember inflation?
I reminded him about the story of the 3 pigs and a wolf.
There were 3 pigs that needed to protect themselves from a wolf. The first pig built a house of straw. The wolf came, huffed, puffed and the house came down. The wolf got the pig for dinner.
The second pig built a house of wood. The wolf came, huffed, puffed and the house came down. The wolf got the pig for dinner, again!
The third pig realised that the problem was not in the quality of material used in the construction, but in the enemy – the wolf! So he devised a plan to tackle that risk. He constructed a house of stone and cement and invited the wolf through the chimney. He kept a pot of boiling water at the fire place and made sure that the wolf was killed.
Similar is the investment story. The risk for Shiva’s father-in-law and father did not come from the Rajus! It came from the enemy and the enemy in their case was lack of understanding; their own ill understanding of risk. That is exactly what Warren Buffet says. Risk comes from ‘not knowing’ what you are doing.
How to tackle the enemy
If all investors know their own financial goals, risk profile, understand their severe limitations in stock picking, accept that portfolio construction cannot be learnt by watching television or ‘googling’, they will become better investors. Here's a good way to start:
Step 1: Identify your financial goals
Write down what you want to buy/ spend on and put a timeline to each item.
Step 2: Identify your risk profile
It's not as difficult as you think. If you are the only earning member in your family which comprises of a wife and 2 children and maybe dependent parents, your risk capacity is low. If you are young, single, you have a fairly high risk capacity. Of course, these are only indicative. Each person's risk profile is a function of various parameters.
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Step 3: Identify asset allocation
For goals within 3-5 years, invest in debt. For goals between 5 to 10 years, invest in a mix of debt and equity. For goals longer than 10 years, invest in equity.
If you have a low risk profile and poor understanding of financial markets, stick to index funds, diversified mutual funds, bank deposits, income funds and gold ETFs.
If you can take risks, and know how to stock pick, only then must you opt for direct equities.
Whatever your risk profile, do not put all your eggs in one basket.
Step 4: Invest regularly
Invest in a disciplined manner. Review your investments periodically.
Lesson learnt
While investing, it is all right if the world thinks you are a pig. Remember the third pig lived to tell the tale!
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