The benchmark equity indices in many global
markets are presently positioned close to their all-time high levels. The
equity shares of new age companies, with relatively untested business models,
are commanding prices, which could be termed “obnoxious” from the view point of
conventional valuation methods. The global debt yields are staying obdurately
low, despite higher inflationary expectations and liquidity contraction talks.
The market value of cryptocurrencies, one of the youngest asset classes, is
also more than US$2trn.
In these circumstances, “Risk” is naturally the
most talked about, and understandably the most ignored, term in the financial
markets. All market experts are highlighting the urgent need to manage “Risk”
for investors.
A quick survey of household investors’
perception about the “Risk”, and their methods of managing “Risk”, however
highlights that “Risk” may actually be one of the least understood, though most
talked about, terms amongst these investors. A significant number of such
investors appear to be carrying serious misconceptions about the risks involved
in investing activities, especially equity investing.
The following observations from the survey are
particularly noteworthy.
“I take calculated risk in the market. I
only buy options. The loss in options is limited while the gains are
unlimited.”
This is the most noteworthy comment from the
survey. This implies that people may be buying naked options, fully knowing
that they can lose 100% of their principal amount, if the option expires out of
money by the end of week/month. They are “investing” in equities, just the way
they would buy a lottery ticket – risking 100% of their capital if the final
outcome does not match their wager; sincerely believing that they are taking
“minimal risk”.
Risking 100% of their principal investment and believing it to
be minimum risk is no less than a wonder, in my view.
The most seasoned participant in the Survey
commented, “I invest only in quality companies. There is no risk in such
investments. The only risk is market price volatility, which I can easily take
since I invest for long term”.
Almost every respondent in the Survey believed
that volatility in the market price of shares and market manipulation are the
most important risks in equity investments. A significant proportion of the
respondent believed that volatility is the only risk, and they do not mind
taking it.
The
respondents had different perception about the “quality” of companies. Most
believed that large cap, debt free, good dividend yield, low beta and
non-cyclical business is “good quality”. Some even took the simple route and
defined Nifty companies as “quality”.
A deeper probe however indicated that a large
majority of investors associate the “quality of business” with the returns they
have personally made in the particular stock. Reliance Industry Limited and ITC
were the two stocks that attracted divergent opinions. It appears equal number
of people find these two stocks “poor” and “good” quality, depending upon when
they bought it and what have been their returns from these. Many respondents
cited some small and microcap companies as “good quality”, since they have made
brilliant returns in these lesser known stocks.
Besides, the market volatility risk, market
manipulation risk appears to be the most popular risk factor amongst investors.
Most of the respondents sounded convinced that “operators” are able to
manipulate the prices of stocks “at will”. Some of them even sounded skeptical,
believing that the over regulation of market functioning is actually helping
these “operators” in their activity. A significant proportion of investors
strongly believed that the market volatility is staged by “operators” to
deceive the gullible small investors, implying that market volatility is mostly
an integral part of the market manipulation exercise of the unscrupulous
elements.
Only a tiny percentage of respondents mentioned
the business risk (company specific) as a major risk element in equity
investing. About two third of the respondents were not aware that companies
like Aban Offshore, Suzlon, JP Associates, Reliance Infrastructure, Reliance
Capital, Reliance Communication, Jet Airways, OBC, SCI, Unitech, and BHEL etc.
were part of the benchmark Nifty 50 index in 2007, and hence prima facie
qualified to be included in “quality portfolios”. Most investment gurus and
revered fund managers owned some of these names during 2007-2016.
An analysis of historical volatility (daily change in the
Nifty 50 index) also supports this observation. In past 14yrs (since August
2007), there have been 154 daily moves of 3% or more in Nifty. Out of this 109
moves occurred during 2007-09; only 21 moves occurred in next 10years (2010-19)
and 24 moves have occurred since March 2020 in the wake of pandemic. The number
of large moves on both the directions has been almost the same. The risk of
market volatility has obviously reduced materially in past one decade or so,
primarily due to the stricter regulation and margining norms post global
financial crisis.
Between the years 2008-2016 there were three major corrections
in Nifty (25% or more). On each occasion, Nifty took more than 13months to
recoup the losses incurred during correction. However, in past five years there
has been only one draw down of more than 25%, and that too has been recouped in
less than seven months.
On the other hand, increased global
competition, accelerated technology evolution, and transformative regulatory
changes, have led to tremendous rise in the business risk. More mid and large
sized businesses face the risk of redundancy and obsolesce today, than ever.
This risk was mostly associated with the smaller and weaker businesses in
previous decades.
The pandemic has in fact enhanced the business
risk in numerous businesses like transportation, hospitality etc. The
commitment to climate change may itself threatened the sustainability of many
businesses that rely on conventional fuels and technologies.
It is conventional wisdom that all eggs should
not be put in one basket. In the principles of investing, diversification is
used as a key risk management and return optimization tool.
One of the key observations of this Survey was
the inadequate awareness of the participants regarding the concept of
diversification. Most participants responded by saying that diversification
means spreading the capital over a larger number of instruments, e.g., stocks,
mutual fund schemes, etc. A diversified mutual fund scheme was invariably
accepted as adequate portfolio diversification.
In
investing parlance, diversification is actually a three layered process. At the
top layer lies an asset allocation plan that incorporates assets which are
mostly uncorrelated to each other in their risk-return profile, e.g., equity,
debt, deposits, precious metals, commodities, real estate etc. The middle layer
relates to the systemic diversification within various uncorrelated asset
classes based on geography, form, security etc., e.g., developed vs emerging
equity; corporate vs sovereign debt; hard vs soft commodities; paper vs
physical gold; urban vs rural real estate, direct equity vs mutual funds, etc.
The third level of diversification is buying a variety of instruments within
one asset class, e.g., equity shares of different Indian companies, or mutual
fund schemes that invest in different sectors or in a diversified portfolio;
debt mutual funds that invest in instruments of different risk and maturity
profiles; commercial and residential real estate etc.
Buying units in five large cap diversified
equity schemes of different mutual funds, having mostly identical portfolios
will not achieve much diversification.
The risk
management matrix is function of the personal circumstances of each individual
investor. The risk tolerance of an individual, and risk management matrix, is
defined by his/her socio-economic status, income stability, health conditions,
etc. Since different investors could have very much different loss tolerance,
the risk management tools to be used in their individual cases would also be
different.
For example, take the example of the following
three hypothetical investors:
Let me elaborate it little further by the
following two real life case studies:
It is
common to associate the risk tolerance of an investor with his age. The almanac
of wealth managers specifies that as an investor grows older, his risk
tolerance diminishes. In my view, associating age of investor with risk
tolerance may not be appropriate. In fact in many cases, the reality may be
exactly opposite.
Take example of these two investors:
Investor Mrs. Singh is 75yr old widow. She has
75% of her Networth invested in rent yielding good commercial properties. Both
her children are well settled in life. She lives in her own house and enjoys
good health.
Investor Mr. Rajan, is a 36yr old Investment
Banker. He has good income, but uncertainties relating to his job are high. He
suffers from diabetes and hypertension. He has home loan EMI, auto loan EMI,
life insurance premium and health insurance premiums to pay regularly. He has a
3yr old child who needs to be admitted to a reputable school this year.
Obviously, the risk tolerance of Mrs. Singh is
substantially higher than Mr. Rajan. But in reality, Mrs. Singh’s portfolio
mainly comprises of bank deposits, debt mutual funds and FMCG & IT stocks
that were purchased good 25-30yrs ago and have grown in value substantially; whereas
Mr. Rajan regularly invests in small and midcap stocks with multibagger return
potential (usually based on the tips he gets during the course of his work);
and has an SIP in Nifty ETF (about 30% exposure to BFSI sector same as his
employment).
It is a
common mistake to take piecemeal view of the asset allocation of investors. The
risk management tools are applied only to the marketable financial investments,
ignoring the other assets and liabilities.
Investor Ms. Bansal has 67% of his Networth
invested in stocks of her employer bank. She lives with her old and ailing
parents in a joint family house. She pays EMI on car loan she took last year
Investor Mr. Mehta has 92% of his Networth
invested in the equity of his own pharmaceutical business, which is well
established and growing at decent pace. He gets very good salary and dividend
from the company.
Asking Ms. Bansal and Mr. Mehta to make any
further investment in equity may not be appropriate in the circumstances.
Asking Ms. Bansal to invest in debt funds with
high exposure to financial sector would add material risk to her portfolio.
Even making fixed deposits in the bank she works with would add material risk
to her portfolio.
Mr. Mehta does not need any regular income. He
already has 92% allocation to equity. A part of his balance Networth may best
be parked in liquid assets that may be converted into cash immediately, should
an emergency arise. The rest he can afford to invest - as angel investment,
venture capital or private equity – in the healthcare ventures which he
understands the best.
For most investors, the risk is synonymous with
the probability of loss. This in my view is a misconception, which primarily
originates from the common tendency of not defining the investment objectives.
In
broader sense, “Risk” means the probability of failure in meeting the objective
of a plan. In the investing parlance, it implies failure to achieve the
investment goals. The failure may be due to lower than expected returns; loss
of capital; and/or lower than expected liquidity.
Focusing on only the safety of capital, usually
distort the entire risk management process. A good risk management plan must
address all the three dimensions of the investment objectives of an investor,
viz., Safety, Liquidity and Returns (SLR).
Safety: The risk
management plan must aim to minimize the probability of the loss of capital
and/or returns.
Liquidity: The risk
management plan must ensure the possibility of liquidating the portfolio assets
at optimum cost and in minimum possible time.
Return: The risk management plan must rationalize the
return expectations of the investor, and ensure that expected returns are
commensurate to the risk tolerance limits of the investor. Lower the tolerance,
lower must be the return expectations.
Let me correlate this to the following very common and
frequent investment advice one would read/listen on media.
This is indubitably a brilliant piece of
advice. However, it may not suit every investor, for different investors invest
with varying objectives and timeframes in mind. Besides, they may have
different temperament and risk tolerance limits.
Investors who did not manage the liquidity risk
well and were forced to sell at the bottom cycle, shall never be able recoup
their losses.
Do note, half the bankruptcies across the globe may be occurring to failure in managing the liquidity risk.
The market regulators are concerned with
protecting the interests of the investors, orderly functioning of the markets
and development of the markets. The objectives are achieved by a employing a
variety of tools, e.g., ensuring full & fair disclosure of information to
all market participants; prevention of unlawful and fraudulent activities in
market; prevention of insider trading; creating reserves to limit the contagion
effect of defaults; ensuring a efficient & secure clearing and settlement
system; limiting excessive speculative activities; ensuring capital adequacy of
the participants, etc.
It is critical to note that the Regulator is
concerned with the systemic risks in the market only. They do not address any
other risk that may be involved in the investing process. Some investors seem
to be nurturing an illusion that it is the duty of the regulator to manage all
the risk for them. They do not even mind holding the regulator accountable for
the failure of businesses and market volatility.
Contrary to the popular perception, the job of
the regulator is to augment the risk taking capabilities of the market
participants rather than stifling the legitimate risk taking.
“Risk hai toh ishq hai”, a famous dialogue from
a popular TV series made on the life of infamous investor/trader of early
1990s, seems to have become anthem of many young (and some not so young)
investors in the equity market. These investors many a times are mistaking
their gambling instinct with their risk tolerance. They flirt with equity
stocks in the anticipation of getting some quick gratification; and not
surprisingly, often end with substantial losses. These investors should rather
spend some quality time understanding the risk in investing and marry the risk
by imbibing it in their investment plan and strategy.
Examples of Risks involved in
various type of investments
·
Business failure risk is the risk that
the business you invested in will be less profitable or fail and the value of
your investment will decline or become worthless.
·
Market price risk is the risk that the
price of your investment will go down when overall markets fall. Though intrinsic value of the investment may
not change materially. You may incur
significant loss if you must sell when market is down.
·
Inflation risk is the risk that the
financial return on an investment will lose purchasing power due to a general
rise in prices of goods and services.
Investment returns must exceed the rate of inflation in order to
increase purchasing power.
·
Interest rate risk is the risk that the
value of an investment will decline due to rise in interest rates. If you lock yourself into a long-term
fixed-return investment and interest rates go up, you would lose the advantage
of high returns.
·
Political risk is the risk that
government actions, such as trade restrictions, or increased taxes will
negatively affect business profits and investment returns.
·
Fraud risk is the risk that the
investment is designed to deceive and misrepresent facts.
