Zero risk in an investment can mean zero returns

Quite often we come across people chasing the best performing asset class of the moment in the quest to earn superior returns with the least or, in some cases, no consideration for risks involved. If the outcome is positive, they wish they had invested everything they had back then. Such behaviour is not uncommon and stems from the fact that most people are oblivious to the concept of risk.

For many years, property and gold were considered as safe avenues for investment and one would get laughed at if she said that their prices could come down some day. Apart from price volatility, there are other inherent risks in these investments which people fail to consider. Here is a look at some such risks that apply to most asset classes.

Market risk: In simple words, this is the risk that the principal invested may not return its full value when you sell the asset. This applies to all investments. Just in case someone thought that investing in the so called safe havens such as gold and bonds would be devoid of market risks, they are mistaken.

Liquidity risk: This is the risk that the asset cannot be sold at the desired time or market price if cash is needed at a short notice. While there is a high level of liquidity risk with property, it is lesser in gold.

Credit risk: This are relevant to bond investments and arises when the borrower defaults or delays on payment of interest or principal. Investors tend to ignore the financial health of the borrower and go for high yielding investments.

Reinvestment risk: Investments in bonds carry reinvestment risk. This is because interest rates prevailing on the coupon payment or maturity dates may differ from the original coupon of the bond.

Risk of unpredictable returns: Standard deviation is used as a measure of risk of unpredictable returns. It measures the movement away from the average in a data set. For instance, for headline equity indices, the standard deviation based on their annual returns falls in the range of 35-37%, for mid- and small-cap indices it is 40-45%, for the gold price index it is about 18%, for the government securities index it is 6.5-7.5%, for bond indices it is 2-4%, for the liquid index it is up to 2%, and for the one-year treasury bill index it is about 3%.

So, if the average annual return on bonds is 7%, a standard deviation of 4% would mean that most of the times the returns would range between 7%-plus and negative 4%, i.e., between 3% and 11%. While making investment decisions, savvy investors prefer to consider risk-adjusted returns, which take into account standard deviation in returns. The past financial market turmoil, especially in 2008, has caused great harm. But it has also made us better informed and increased our awareness towards risk. With increased thrust on financial inclusion in India, we would hopefully see increased awareness and change in investor behaviour towards risks as well.

In the financial world, the phrase ‘risk-free rate’ refers to yields on treasury bills. But are they really risk-free? All investing involves taking some form of risk, even if it is not that apparent. Talking about risks which are not apparent but are present, brings forth the classic example of deposits placed with various institutions which earn a fixed rate of interest. Technically speaking, these offer predictable returns (negligible to zero standard deviation), which may also be the best risk-adjusted returns. But there are other risks to consider. No, I am not talking about credit risk, reinvestment risk or even illiquidity risk, which are very much there and which most text books will teach you and prepare you for. I am pointing towards the risk of loss of purchasing power, either due to inflation or due to taxes. Are investors actually earning real returns after taking inflation into consideration? This is the risk of playing too safe or being too conservative. I am not suggesting that one should take more risk to get proportionately higher returns. But the least one could do is to follow a proper asset allocation depending on her investment horizon, goal(s) and risk appetite. Generally, a financial adviser helps one with a suitable asset allocation depending on individual inputs shared with her.

Let’s take an example to understand this. If you are investing for retirement, which is some years away, then keeping your savings in low-yield investments could stunt the long-term growth of your savings pool. You would then find it difficult to maintain your standard of living after retirement. Conversely, if you’re nearing or have already retired and are counting on withdrawals from your savings pool to pay for your living expenses, a meagre return on your savings would force you to keep those withdrawals at a modest level—which you would then increase by the inflation rate each year to maintain purchasing power. Pull out more, and you would run a high risk of running out of money early in retirement.

The bottom line is that you can’t eliminate all risk when investing, and the more you focus on avoiding just one peril, the more vulnerable you’ll be to others. By diversifying smartly, you should be able to protect yourself adequately against a variety of risks, and lower the chances that any single threat will do your portfolio in.

There’s no such thing as a risk-free return, and it’s not a right-now problem based on the level of the market or the low returns on deposits, but it’s about how risk works. The same rule applies to stock picking as well. When a company’s stock is available at a certain price, one needs to ascertain whether there are risks that are not apparent but are present and which need to be considered to arrive at the true value of that stock. These could be the risk of a faulty business model, weak management or corporate governance structure, weak financials, and so on, all of which impact the sustainability of the company’s earnings. If one considers all the risks and then prices the stock accordingly, the outcome of the investment is likely to be a better risk-adjusted one.