Right asset allocation essential

A few years back, during a family vacation, on our way to a water theme park I saw a signboard for skydiving near Austin, TX. The price was so attractive that I couldn't resist, although it wasn't part of the plan, I wanted to experience it. My brother, a year younger to me dissuaded saying that it's too risky while my wife stopped talking to me on just mentioning about my plan. I felt soar missing it and tried to put across the statistics on the fatality or accident rates during skydiving in the US.

A casual Googling on mortality rate in skydiving puts the odds at 0.000002 per cent i.e., about one tandem student fatality every 500,000 tandem jumps. Further research on that topic had shown me a statistic of about four deaths in four million jumps in 2018 in the US. I tried to reason with my family on how we get scared of flying in the planes while the statistics actually are way lower than that of the road causalities. These figures stand at one fatal accident for every 5.58 million flights in 2018. I still couldn't win their approval for the adventure.

While the risk is not completely off the table, the possibility of event happening is so low, but our perception is quite the opposite. Consider this with casualties due to rash or speed driving on a highway, the probability is much higher, but we witness many trying to push the throttle to the max. So, this brings us to conclude that risk is defined not as it is but as we perceive it. The same is the case with investing. High conviction levels in an investment avenue or philosophy makes us to ignore or downplay the risks associated. We tend to become blind or numb to the increased risk we pursue in trying to get the best out of that situation.

Continuing more on the skydiving topic, have you ever wondered, why was the diver wearing a helmet? For all the divers, there's an emergency chute provided as a back-up, so would one additional chute be sufficient or need another one or even more? All these safety measures have led to popularity of skydiving as a sport. But despite the increased safety measures, the mortality rate remained more or less at the same range. This has got to do with the behavior of humans as Bill Booth, the pioneer of skydiving observed that 'safer the skydiving gear becomes the more chances skydivers will take, in order to keep the fatality rate constant'.

This brings into focus an important behavioral investing bias called Peltzman Effect. The Peltzman effect states that people are more likely to engage in risky behavior when security measures have been mandated. This was named for Sam Peltzman's postulation about mandating the use of seatbelts in automobiles. In other words, it's simply is about risk compensation, which suggests that people typically adjust their behavior in response to the perceived level of risk, becoming more careful where they sense greater risk and less careful if they feel more protected. So, this kind of explains why my folks didn't allow me to get on that adventure.

Now drawing parallel to investing, we tend to get carried away with the market happenings and sometimes make stretched bets that catapult our risk beyond our tolerance levels in trying to mitigate the fear-of-missing-out (FOMO). Particularly, this is true when investors find safety in undersized contrarian allocations. For instance, conventionally it's understood that debt instruments have inverse relationship to equities and vice versa. If an investor were to invest in debt where the allocation is only 10 per cent to that of the 90 per cent equity would it help the portfolio? Equating the helmet in skydiving to debt portion of the investment, a mere allocation wouldn't help sustain the balance in the portfolio. It requires a proper allocation that suffices or offsets the risk.

Though, there's no such magic figure for the right mix, it should ideally reflect the risk appetite of the individual. The best way to come trumps over this bias is to have an optimal asset allocation where each asset class is less related or unrelated to each of the other constituents and at a proportion that brings in balance during risk events.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)