Risk versus Returns

Published on Fri, Sep 24, 2010 at 13:19   |  Updated at Fri, Sep 24, 2010 at 14:13  |  Source : Moneycontrol.com

Every investment has an attached risk
'Just buy this blue-chip stock, there’s no risk at all.' For most people who invest in shares there is a good chance that you’ve heard someone say this before. For most people who just put their money away in bonds or deposits, one of your main reasons for this probably is -‘I don’t want to take any risk at all, I just want my money safe.’
Are these statements true? Is investing in bonds or deposits completely risk-free? Or investing in blue-chip stocks necessarily very low risk? NO.

Whenever more than one outcome is possible from an investment, there is always some amount of risk. Only the level of risk is different.

Use risk to analyse expected returns
While investing, risk is measured to evaluate the kind of returns you should expect from the investment. Or your return expectations should be based on the level of risk you can bear. In principle, the higher the risk, the higher the returns that should be required.
Empirically returns across various asset classes show that investment in equity shares give the highest level of returns in the long-term, followed by corporate bonds and deposits and lastly bank deposits and government debt. Not surprisingly, the level of risk is also in the same order.
You might be saying - how can debt be risky? It is.

Companies that run into financial trouble could delay your interest payments or even default on paying back your money. Even government debt has some amount of risk. How? Simply put, governments like companies also face the risk of financial problems. However, lack of funds for a company could result in the company defaulting on a loan repayment. But a government can always print more currency and repay its borrowings. So you will get your money back. BUT, there is a hidden cost (risk). Printing more currency is likely to lead to higher inflation and hence lower real returns on your investment (see our article Impact of Inflation to understand about real returns).

Agreed that the chances of governments or well-managed companies getting into serious financial troubles are low. But that is only difference in the level of risk. There is a risk attached, and that cannot be questioned.

Understanding risk vs return essential for good financial planning
You might ask - why is it so important to understand the risk versus return relationship? Because if you don’t, it is quite likely that your investment returns will not match your risk profile and consequently you are not managing your hard-earned money well. A wasted opportunity, as even a small difference in your investment returns (at the same level of risk) can make a BIG difference to your financial wealth (due to the astounding Power of Compounding).

To understand the importance of managing your money well read Guide To Financial Planning. This article highlights why financial planning is not as difficult as it sounds and how you can easily make your hard-earned money work for you.
Also you can use our Risk Analyser to understand your risk profile (both your risk-taking capacity and your risk tolerance level) and read The Need To Diversify to understand how you can increase your expected returns while not increasing your level of risk.

Risk versus Returns

Every investment has an attached risk
'Just buy this blue-chip stock, there's no risk at all.� For most people who invest in shares there is a good chance that you've heard someone say this before. For most people who just put their money away in bonds or deposits, one of your main reasons for this probably is -I don't want to take any risk at all, I just want my money safe.

re these statements true? Is investing in bonds or deposits completely risk-free? Or investing in blue-chip stocks necessarily very low risk? NO.

Whenever more than one outcome is possible from an investment, there is always some amount of risk. Only the level of risk is different.

Use risk to analyse expected returns
While investing, risk is measured to evaluate the kind of returns you should expect from the investment. Or your return expectations should be based on the level of risk you can bear. In principle, the higher the risk, the higher the returns that should be required.

Empirically returns across various asset classes show that investment in equity shares give the highest level of returns in the long-term, followed by corporate bonds and deposits and lastly bank deposits and government debt. Not surprisingly, the level of risk is also in the same order.

You might be saying - how can debt be risky? It is.

Companies that run into financial trouble could delay your interest payments or even default on paying back your money. Even government debt has some amount of risk. How? Simply put, governments like companies also face the risk of financial problems. However, lack of funds for a company could result in the company defaulting on a loan repayment. But a government can always print more currency and repay its borrowings. So you will get your money back. BUT, there is a hidden cost (risk). Printing more currency is likely to lead to higher inflation and hence lower real returns on your investment (see our article Impact of Inflation to understand about real returns).

Agreed that the chances of governments or well-managed companies getting into serious financial troubles are low. But that is only difference in the level of risk. There is a risk attached, and that cannot be questioned.

Understanding risk vs return essential for good financial planning
You might ask - why is it so important to understand the risk versus return relationship? Because if you don�t, it is quite likely that your investment returns will not match your risk profile and consequently you are not managing your hard-earned money well. A wasted opportunity, as even a small difference in your investment returns (at the same level of risk) can make a BIG difference to your financial wealth (due to the astounding Power of Compounding ).

To understand the importance of managing your money well read Guide To Financial Planning . This article highlights why financial planning is not as difficult as it sounds and how you can easily make your hard-earned money work for you.

Also you can use our Risk Analyser to understand your risk profile (both your risk-taking capacity and your risk tolerance level) and read The Need To Diversify to understand how you can increase your expected returns while not increasing your level of risk.

Maximum Gain with Minimum Risk

Of the total population that saves and invests, only a very tiny fraction ever invests in any asset that is backed by equity. Given that equity-backed investments provide better returns, there is no other reason for this except that equity carries a substantial risk of loss. Losses are integral to equity investing, and that's something that investors can never get used to. This inevitably leads to what amounts to the holy grail of financial products – if equity could be packaged in such a way that the risk of loss could be eliminated, then such a product would be extremely attractive.

In many countries, equity funds which can protect the original capital are popular products. In India too, there are a handful of such mutual funds that promise to get you some of the benefits of equity investment while ensuring that there's no chance of the value of your investment falling below the original sum you invested. There are existing funds from Franklin Templeton and UTI, and Birla Sun Life has just launched a couple of such funds, one of three years tenure and another of five years. These are all closed-end funds and the capital-protection is there only if you invest in the NFO and redeem at the end.

The way capital protection works in such funds is that the fund manager puts away in safe debt instruments enough assets so that at least par value can be delivered at the time of redemption. For example, consider a fund that collects Rs 100 crore from investor for a tenure of five years. The basic capital protection goal of the fund is to ensure that at redemption, it has at least the original Rs 100 crore. So what the fund manager has to do is to construct a quality debt portfolio that matures around the same time as the fund's redemption. Now, let's say that that such a debt portfolio will yield 7 per cent over that period. This means that if the fund manager invests Rs 71.3 crore in this debt portfolio, he can be assured of having at least Rs 100 crore to meet the minimum redemption value. This leaves him with Rs 28.7 crore to invest in equity and enhance his investors' returns. Actual funds can change the recipe a bit but this is the basic concept.

It's important to note that these funds are not 'capital guaranteed' but only capital-protection 'oriented'. In all such funds, the 'capital protection' is a goal and not an obligation. By law, funds are not allowed to offer guarantees and SEBI's rules regarding such funds term them as 'Capital Protection Oriented' funds. The 'oriented' part makes it a sort of a best-effort exercise. Also, their closed-end nature means that you can't invest whenever you want to or in an SIP-you'll just have to wait for a fund company to launch such a fund.

In India, the appeal of such products is limited because of the supply of high yielding fixed income options, some of them with genuine government-backed guarantees. Here's how to use one such option-the post office deposit to get all the benefits of a genuine capital-guaranteed (not oriented) fund. All you have to do is to replicate the above strategy with the government's post office deposit. This pays you an interest of 7.5 per cent per annum, compounded quarterly. This means that of the total amount you'd like to deposit for five years, you should put 69 percent in the post office and the rest in any good open-end large cap equity fund.

Not only will this arrangement give you a government-backed capital guarantee, but the equity part will actually be liquid. Moreover, you could actually deposit the money in the post office's monthly income scheme (8% returns) and invest the monthly income in an SIP. This would combine the advantages of an SIP with capital guarantee.

Tips to help you negotiate volatile market conditions

The stock markets here have yielded good returns over the last one year as the economy is back on the growth path. The strong performance in the stock markets is backed by a solid mop-up by domestic funds and strong inflows from foreign funds.

As the markets scale new highs, there is more volatility to contend with. Valuations are no longer cheap and investors who invested at lower levels look at booking profits, adding to the volatility.

These are some of the significant factors contributing to volatility in the stock markets:

Investor sentiment:
Investors and analysts across the globe are divided on the sustainability of the global economic recovery. There are factors like a bulging deficit in the US, risk of sovereign default in some of the European nations, and the rising inflation rate in some Asian economies.

These concerns are not totally baseless and hence, analysts are keeping a close track on the developments around these issues. Another recession triggered by any of these factors could be much more damaging and long-lasting.

Therefore, there are panic waves in the markets every now and then triggered by some of these factors. Global currency fluctuation is another fall-out of the various developments happening in the global arena.

Growth and inflation:

This is one of the few economies in the world that have almost recovered from the slowdown. However, the challenge here is to contain the inflation rate which has crossed comfort limits.

The Reserve Bank of India (RBI) has taken steps by tightening the monetary policy to establish control over the inflation rate without impacting the growth rate. However, significant results are yet to be seen as the inflation rate is not showing any signs of cooling down.

This is another area of concern in the stock markets as a rising inflation rate would warrant harder actions from the RBI, and that may affect the growth rate of the economy.

The stock markets have appreciated quite a bit over the last one year and the valuations are no longer cheap at the moment. Analysts believe the economic fundamentals and corporate performances do not justify further sharp appreciations from the current levels. However, if the foreign fund inflows continue, the markets might scale up to new highs.

Here are some strategies for investors in the current market conditions:

Investors with low risk appetite:

Investors with a low risk appetite should look at investments in blue-chip stocks (preferably index stocks) or mutual funds, with a long-term perspective.

Historically, it has been seen that index stocks give a good return over the long term and come with relatively much lower risk. Diversification is the key in volatile and uncertain investment conditions. Investors should look at investing in diversified stocks and equity-based instruments as well as debtbased instruments.

It is important for investors to track global market movements and study the reasons behind any sharp corrections. Take cautious decisions while investing in stocks which do not have any specific reason to take a severe beating.

Tips to help you beat stock market risks

Risks in stock markets

The Sensex knows no smooth ride. Huge crashes are more often reminisced and abhorred by small individual investors who have lost their hardearned money. The year 1992 witnessed the Sensex plummet from unimaginable highs. Not very long ago, in the year 2000, it wasn't kind to investors either.

The Internet sector and other related fields saw extreme buyer interest and price boom. Finally, the dot com bubble burst, bringing down share prices dramatically and many firms went out of business.

The past few months witnessed a fall of more than 50 percent in the domestic markets. With an increased impact of global forces and foreign institutional investor (FII) involvement, the reason for the fall is myriad. It is not only local forces but also a host of global factors that pulled the markets down.

Investors who have their portfolio's worth down by half were looking at fixed deposits and other safer avenues to park their surplus. The element of risk in equities is an ugly deterrent.

Weak economy: When the overall economy is at its ebb, unemployment at its peak, real estate sector on a downslide and growth eluding, economic risk factors come into play. A weak economy will impact the stock markets.

Inflation: It hurts investors in fixed income instruments the most. Stocks are often considered a hedge against inflation.

Poor performance: What happens when you invest in a company that doesn't meet your expectations? Corporate risk comes into play when the company does not perform as well as you had hoped it would.

Market risk: Sometimes, regardless of how valuable your stock worth may be, the market may choose to completely ignore it and chase the next new arrival. A new technology or a new medicine may be a temporary craze with investors. Market value risk refers to the situation when the market turns against your picks.

The best way to beat it is to diversify across sectors and reduce the negative impact. Some investors perceive this as an opportunity to pick up value stocks at bargain rates.

Volatility: The relative rate at which the price of a security moves up and down is referred to as volatility. Volatile returns from markets adversely impact economic growth and investor enthusiasm. If the price of a stock moves up and down rapidly over short time periods, it is said to be high in volatility. Low volatility can be seen when the price almost never budges.

Managing risk

There is a two-fold approach to annihilating stock market risks to a large extent. Diversify across sectors. Putting all eggs in a basket may not be the right thing. Invest in the markets with a long-term perspective.

Irrespective of erratic market behavior and extreme volatility, the returns are stable and lucrative over the long term. Invest in worthy value picks across welldiversified asset classes and harvest stable returns over the long term.