Our advisory methodology
Risk is a universal concept associated with investing. While risk can be objectified in some situations, it gets fuzzy and subjective in Personal Finance. This is because in personal situations, risk involves emotional biases. These biases cloud individuals’ judgement.
The PCR TriangleⓇ is a framework to objectively deal with risk by distilling it into its components. It intends to reconcile
- the Risk Preferences (the emotional component of risk)
- with the Risk Capacity (the numerical component of risk), and
- the Risk Requirements (the investment objective component of risk).
The emotional component of risk
Individuals have different personalities owing to hereditary (factors individuals are born with), environmental (factors shaped by the environment that individuals grew up and live in), and situational (experiences which happen by chance to individuals throughout their lifetimes) factors.
This personality influences how individuals perceive investment risk and shape their preferences. These preferences strongly affect the decision-making of individuals regarding Personal Finance.
At Modulor Capital we measure risk preferences and classify them into 3 buckets – Conservative, Balanced, and Aggressive.
These buckets determine exposure to volatility, bearable portfolio drawdowns, and the expectation of returns for the investor.
The numerical component of risk
Risk Capacity is the ability of individuals to take risks with respect to the money available to them.
Capacity pertains to the amount of money that individuals can earn to assume risks, and is also closely related to the amount of money they can lose by taking risks and still surviving through negative outcomes.
Wealth levels of individuals and their earnings do not change quickly/ This makes capacity a mostly non-transient variable that can be easily measured.
At Modulor Capital we classify Risk Capacity into 4 buckets – Beginner Investor, Covered Individual, Aspiring Rich, and Established Rich.
These buckets determine the type of instruments and minimums investors can take up when investing.
The investment objective component of risk
Investing is done best when there is a target to be achieved at a particular time in the future. The Risk Required to be taken determines whether the target set by the individual is viable or not.
If an individual has a certain funding capacity but is risk-averse and chooses a less risky investment than required then they will fall short of the target in the stipulated time.
Contrastingly, if an individual is risk-seeking but does not have the capacity to fund the goal then they may end up taking risks that are likely to lead to a loss. In this case, too they will fall short of the target.
Risk Requirement is inert to the individual’s preferences or capacity. It simply dictates that this is the amount of funding and rate of return required if you want to reach the specified goal in the specified time, given the Present Value of the Corpus and the Final Value of the Corpus.
At Modulor Capital we have identified three prevailing themes running the lives of individuals and families – Wealth, Goals, and Cash-flow.
These buckets determine the type of investment strategy that needs to be employed in order to attain the investment objective.