Modern finance theory, whichever methods we examine, bases its analysis on the risk-return trade-off. It is a pairing which, through being repeated time and time again, we have come to regard as unique and inseparable, and upon which investment decisions are based. Any proposal offering a more attractive return than is normally achieved tends to prompt the question «but what is the risk?», without delving any deeper.Banks, for example, when recommending investments to their customers (without going into the quality of what they are selling), do not usually stop to consider whether the product is suitable for the customer. Thus, for example, we come across cases – which, unfortunately, are true – such as that of an elderly lady whose savings were invested in leveraged Argentine debt, to make matters worse, in the pre-corralito era; or that of a top-flight footballer whose entire salary for that year had been invested in dollars at an exchange rate of 1.15$/€, because «it was a magnificent opportunity». But there’s no need to go to such extremes. I’m sure most of you have, on more than one occasion, been approached by a bank adviser offering their products on the grounds that they offer good prospects for returns, that the investment risk is minimal, and so on.
At best, as the height of a banker’s expertise, they might recommend investing small amounts in higher-risk products – a practice known as «asset allocation». But realistically, in most cases they will simply recommend buying whatever product or fish they happen to have on offer at the time.
However, all these analyses lack a third element, without which the investment decision is completely flawed: personal circumstances – those intangible factors (it is not possible to quantify whether an individual is married with children, or their aversion to investing in foreign currencies) which, in our view, must undoubtedly form the basis of any decision. Simply overlooking them without giving them due consideration strikes us as such a significant error in the strategic planning of family wealth that it jeopardises its sound performance over time.
Let us take the example – highly simplified but illustrative – of the Christmas Lottery, in which the variables of return and risk are clearly defined and well known to everyone: it is possible to win a huge prize, but the chances of this happening are very slim. So, what makes someone compulsively buy every ticket offered to them by family and friends one year, yet buy none the following year? Of course, this decision would seem illogical on the face of it, unless one takes the circumstances into account. Perhaps the person is getting married and has decided not to play in order to save money for the wedding, or perhaps they have decided to put all the money they were going to spend into a savings account, tired of seeing their euros – and their hopes of becoming rich overnight – vanish into thin air year after year.
For this reason, diversification – or the allocation of proportional shares of assets based on the risk-return ratio (Asset Allocation) is merely the tip of the iceberg when it comes to the circumstances surrounding investment, which take into account not only the portion of one’s assets to be invested but also a myriad of factors intrinsic to and affecting the investor:
Age, marital status, your propensity to spend (or save), whether you have children, your future aspirations, your career prospects, how many times a year you wish to travel, the additional enjoyment that can be derived from an investment (a flat on an exotic beach), the success or failure of previous investments in terms of the proportions and risks defined by your Life Balance and your potential for reinvestment, the strategic timing of the investment itself, as well as the proportion of assets allocated – these are just a few examples of what constitutes the circumstances surrounding an investment. As you can see, as we go through these circumstances, the simple risk-return ratio becomes less of a key factor in investment decision-making. To make this clearer, let’s take an extreme example: a person with a stable income spending 3 euros on the ‘Primitiva’ lottery, with the prize money intended to pay off a relative’s mortgage who is in financial difficulty, is by no means an aberrant investment, whereas betting half the annual benefit of an unemployed person with ten children, who would use the prize money to buy a yacht, is not only absurd but immoral and sickening. However, the risk-return ratio on which most bankers and financial advisers tend to rely exclusively is identical.
Carrying out an analysis of the individual’s (or family’s) circumstances forms the basis for drawing up the Life Balance, which, like the circumstances themselves, will change over time and, furthermore, helps to prevent poor investment decisions. Without the benefit of this analysis, the circumstances determining the investment could be as simple as the mood we are in on the day the decision is made.