Knowing your risk appetite matters

Most of us have probably came across these scenarios when approaching investments.

"Invest only what you can afford to lose"

"Put a little, perhaps 10% of your capital, in high risk activities such as trading"

"Since there's a chance that I might lose everything, I shouldn't invest a substantial portion of my capital"

Wealth as a totality

While the above notions are not exactly wrong, let's consider the following, Mr. A and Mr. B both start off with a capital of $10,000, with similar liquidity needs and risk appetite. The only difference is that Mr. A knows what he is getting into while Mr. B assumes that every investment is a risky asset that might lose everything.

Mr. A, holding a diversified portfolio, has quantified that the maximum losses in a 99% confidence interval is 10%. This means that 99% of the time, losses will not exceed 10%, because obviously nothing is guaranteed. Mr. A is comfortable with losing 5% ($500) of his total capital, and as such he places $5000. With this, 99% of the time he will not lose more than what he is comfortable with. He places the rest in a fixed deposit yielding 2%. A typical market portfolio Mr. A bought into would yield approximately 8%, he thus earns

(5000*0.08)+(5000*0.02) = $500, a 5% yield, on his wealth*, barring unforeseen circumstances.

Mr. B, assuming that any invested amount could be lost, simply placed $500 in a similar market portfolio, because his friend's mom's cousin's second uncle told him that the stock market is dangerous and the next day the bank might come to liquidate your assets if things went south. He places the rest in a similar 2% FD. End of the day, he would earn

(500*0.08)+(9500*0.02) = $230, a 2.3% yield, on his wealth, ceteris paribus.

*The reason I use the term 'Wealth' is simply due to the fact that people only track the performance of the investments, be it FD, unit trusts, stocks, bonds, etc. and this would undoubtedly give an unfair comparison between people of different risk appetites. In order to assess an individual's investment acumen and risk appetite, the performance of their wealth should be taken as a whole, including cash equivalents, bank deposits, and money stashed under the mattress.

While this might seem oversimplified, fact is many people tend to keep their assets in liquid cash (not even FD), simply because they overestimated the risk of the market due to the lack of knowledge. Yes, there are absolute trash of stocks that could go to zero the next day, but most aren't. The risk is there, but for an established index or large-cap stock to crash, the probability is infinitesimal. That is akin to saying that you might get struck by a lightning bolt when you step out of your house, do you not go out almost everyday?

Historically the market has proven to crash more than 50%, such as the great depression, the dot-com bubble, 2008 financial crisis, and the more recent 2015 china stock market crash. However, nothing stays down forever, things do recover, provided you are not buying into some trash security in the first place. Someone who overestimates the risk of a market will accordingly place a much smaller amount of assets into generating returns, and would simply lose out because of that (The professional term is cash drag). By understanding clearly the risk and return of your investments, it allows one to feel and actually be safer investing a larger portion of their cash, liquidity needs aside.

Rainy days and emergency funds??

Speaking about liquidity, some people prefer to have money in the bank in case 'something happens', or people who keep tons of cash liquid 'for a rainy day', contrary to popular belief, people who invested a huge chunk of their cash are able to liquidate them for their 'rainy days'. It is not locked up forever. Yes due to an emergency liquidation, their capital might be 10% lesser, while your cash if safe. However, in just less than 2 years, the investor would have easily returned more than 10% while your liquid cash is eroding in the bank.

If you are sure that within 2 years your 'rainy day' will happen. If you are confident that you will require that money in 2 years time, then they are not investable in the first place, that isn't liquid at all, that's a sinking fund. The informed investor will also not use this sum of money in risky assets, so plan well and make sure you understand what monies of yours are investable and what aren't.

Personally, my 'emergency' funds simply comprise of 3 months of daily expenses + 20% of the replacement cost of my essentials such as shoes, wallet, desktop PC, bed, phone, etc. This proportion might differ from person to person but I am fine with 20% because obviously I am not going to need to replace everything at once. Rest of the liquidity goes into some sort of income generation or will be.

Thanks for reading!