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Investments and Risk

, July 10, 2015, 1 Comments

investments-risk-MarketExpress-inEvery new investor is excited about his investment ventures. In almost all of the cases, he is completely unaware of the risks associated with his investments. The general concept is that the risk is present only if you are putting your money in the market. The people who utter these words do not know what is meant by the word ‘market’.

People do not believe that ‘market’ has debt products whose associated risk is almost equal or less than the ‘fixed deposit products’ or endowment plans. Not knowing the risk is the risk. This article highlights the discussion that happened between my friend and me on the ‘investment and risks’.

Recently, my friend asked me what are the risk-free investment options available to an investor? The immediate response was off course – None. There are no free lunches -yes, he was disappointed but he asked me and I had to say what was true. There was no point in saying that, “yes, the market is safe if you invest for a long term”. To say that, one should know what is long term. I have no idea on what is long term. Having said that, I do believe that as the number of years of ‘staying in the market’ increases, the chances of loss decreases. Mathematically it has been proved that there is zero probability of losses if the holding period is more than 10 years. However, it is again based on historical values and probability theory. So this theory or mathematical analysis does not mean that there is no risk if you invest for more than 10 years, in the market.

Further in this conversation he told me that, “On TV, they say that mathematically there are 21% gains in last 3 years in equity. So I think 3 years is sufficiently long term and there is no risk involved for keeping money and redeem it after 3 years. Again, I had to disappoint him. I forwarded him Subra’s article. And this is an awesome article. It highlights how we are severely hindsight biased and have no clue from where the risk comes. Read the comments as well. It cleverly highlights that if the risk is not seen in last few years it does not mean that he is dead. May be risk has slept or just in comma temporarily.

The Subra’s article made sense to my friend and he wanted to know more about the risk. So we took the conversation forward and started listing the investment and their associated risks.
I listed him few investments that I know and the corresponding risk. Let us start with basics and then move to the sophisticated investments

Saving Account
The obvious risk is bank defaulting on you. The amount that you have in the bank is insured… only till 1 lakh rupees. Need more surprise? This 1 lakh is inclusive of your savings amount, RD amount and FD amount!

Need an example:

Bank RD amount accumulated: 23000

Bank FD amount: 75000

Saving account: 50000

If the bank defaults, you can (theoretically) claim only 1 lakh including of all the vehicles.

Now say, you bank only with government banks like State Bank of India. So what’s the risk? Off course, you keep on losing your money to inflation. The interest earned is only 4% and the inflation continues to grow at more than 9%. Essentially, you cannot use Saving Bank account as investment strategy (except for the “emergency funds“). Saving Bank account can be treated as temporary shelter to the money.

Bank FD and Bank RD
Again the same things as discussed above. The default risk and inflation risk looms here. The FD and RD (or even PPF) returns are around 8% only.

Company FDs
People are not very much familiar with company FDs. However, they function similar to bank FD with added amount of risk! Here, any private company annually or biannually announces opportunity to have fixed deposit with them. The people would pay an X amount to them for Y number of years. On the maturity the company agrees to give them interest at Z%. However, there are numerous conditions for the payout like the company should be profitable, surplus amount should be available with them and so on. The company may choose to delay the payment too. Hence, they suffer from multiple risks like default, fraud, delay and inflation. There are numerous cases where the company refused to pay any amount and showed clause in the contract that a company can default. Hence, there are ratings involved like A, AA or AAA ratings. These ratings indicate the company’s history of honoring the payments and other financial statements.

Endowment plans
Endowment plans by LIC are free from default (since they are backed by the government of India). However, they suffer from the risk of inflation and most importantly liquidity risk. You cannot use the money before it matures. There are high penalties if you take money out before the agreed date.

Government bonds
These are default proof, meaning, Government will pay you back the agreed amount. The interest is typically same as bank FDs. However, they can be traded in the secondary market for some gains. Again, there would be taxation and similar components reducing your gains and finally, it would be more or less the same value. They also suffer from volatility in short term due to interest rate fluctuations by the RBI. When RBI changes repo rate or CRR, it impacts Government bonds. You need to be constantly in touch with the market news to time it in the secondary market.

Direct Equity investment
These are highly volatile investments and you need all sorts of qualities like strong gut, good will power, patience, common sense and ability to read financial papers like balance sheet. If you have all these qualities, you can jump in there. The risk here is the company may default and you will not get anything. The shares may be worth nothing. The owner may carry out certain risky transactions on his own and suddenly the good-looking balance sheet becomes debt-ridden. Till the news is out, the insiders or the smart investors would have already sold the shares and there would be nobody to buy from you.

Another example is: For a company – the financial statistics are good, the balance sheet is decent, the PE ratio is low and everything is honky donky. Suddenly, there is news in the market that the company’s product has some harmful element or not fit for consumption. Zooommm, the share goes down. The company may or may not come up from the loss. However, you have to face the volatility.

Futures and options/ intraday trading
This is the mother of all the risky investments. 95% of the investors do not have any idea what they are betting on, why they are betting on.

Classic example is: After BJP came in power in 2014, the market went up. People bet on the ‘gujarati’ industries. However, that did not turn out to be 100% true. Similarly, during the Delhi elections, BJP lost. People started predicting that market will go down tomorrow and everybody started shorting. The market went up on the next day (along with the blood pressure of many people). This is complete speculative investment and sane investors must stay away from it.

Commodity (Gold, Silver, Copper, etc)/ Currency trading
This is like real estate investment. People think they are making huge profit. Even the builder thinks that he is making a killing. However, in the end, only bank makes money. Similarly, in this case, the broker makes money, for himself.

Mutual Funds
Here, the actual investments are not mutual funds. Mutual funds just buy other products by pooling your money. So what is the underlying instrument? Essentially, Mutual Fund Company buys stocks and government/corporate bonds. Some AMCs claim that they buy and sell gold for you, when you buy their ETFs. So Mutual fund has risk of all the elements that it deals with. Example: An equity fund will come with a risk of stocks.

Moreover, it is a common myth that – More the risk; more is the returns. If that is the case, why are the preachers not buying King Fisher shares? Why there are very few buyers for Financial Technology services?

Learning for today –

Imagine a hunter running after an animal with a gun in his hand. The jungle is dense and there is dark out there. The trees are tall. Many trees have fallen, obstructing the hunter’s path.

The hunter is aware of the risk that animal can kill him. However, he is of the opinion that the gun in his hand negates or neutralizes the risk. However, he may not have considered the risk of a gun getting a jam at the crucial moment or his aim going awry at last moment and the animal over powers him.

Whatever may be the case; he has decided to live with the risk, so can you.






  • LAKSHMANAN RAJAGOPALAN

    Clean and lucid language,  Anybody can easily understand the subject. Thanks a lot