November 23, 2017

The Complex Nature Of Risk

Here’s a question.  Which of these investment choices would you consider to be more risky: equity funds or debt funds? 

It may appear to be a no-brainer that equity funds are riskier than debt funds.  That’s because to many of us, risk in an investment is about losing some or all of the money that we invest, and there is a greater chance of that happening in an equity fund than in a debt fund.  We could draw a similar conclusion if we were to go by the so-called “riskometer” that every mutual fund scheme document carries, under which schemes are classified by the extent to which an investor’s principal is at risk.  Typically, debt funds are shown as having low to moderate risk whereas equity funds are shown as having moderately-high to high risk.  Yet the reality is that risk is too complex to be assessed in this way.  Having a thorough understanding of risk can help us make better investment decisions.  And while this is a subject that is large enough to fill a book (indeed, many books have been written on risk), in this post, I’ve made an attempt to briefly present some key points.

Risk is best seen in context
To go back to the question at the start, my answer to it would be: “It depends.”  If our investment tenure is, say, a year, then the chances of losing money on an equity fund are much, much higher than the chances of losing money on a debt fund.  However, if our investment tenure is ten years, going by past data, the chances of losing money on either an equity fund or a debt fund are pretty slim.  In fact, over a period of ten years, it is very likely that someone who invests only into equity funds will accumulate more money than someone who invests only in debt funds.

Risk isn’t always about losing money
Doubtless, the risk of losing money is a very real one, most notably in the short term.  In the long term, though, the dominant risks in investing are not being able to beat inflation, or not being able to adequately fund our long term goals.  What if, thanks to inflation, ten years from now, our investments are not worth what they are today?  What if we don’t have enough money at the time of retirement to enjoy a comfortable lifestyle?  By being focussed only on not losing money, there is the danger of being caught unaware by long term risks such as these.  And that’s not all.  There is another risk that we need to be wary of: that of not getting back our money back when we need it.  Among mutual fund investors, this can particularly impact those who invest in closed end schemes, and try to exit before the maturity of the scheme.

Risk comparisons are difficult to make
While debt funds carry a lesser short term risk of losing money compared to equity funds, they carry a much higher long term risk of underperforming the rate of inflation.  So can we really make a fair comparison between debt funds and equity funds, as to their overall riskiness, so to speak?  Fact is, we can’t.  The way out is to assess the extent to which each risk matters to us.  Based on that we can decide how much of each investment option we should have. 

Our strategy can increase or decrease risk
Consider, for a moment, the risks in driving  a car.  To some extent, these are linked to the way that the car is built (how strong or weak is its body, what safety features it has or lacks etc.).  However, a lot would depend on how we drive the car.  For instance, driving the car rashly, without wearing a seat belt, increases the risks involved.  The same applies to investing.  To take an example, the risks in investing in equity funds are greatly magnified if we invest for short term gains, and without a care for market valuations.  On the other hand, investing for the long term, and by staggering our investments (instead of investing at one go) reduces the risks involved. 

Risk management begins with knowledge
If you think about it, risks are but obstacles in the path of getting optimal returns.  We cannot avoid them, but we can overcome them.  To do so, we first need to know their nature.  While the earlier points offer clues to the broad nature of risk, one way to understand the finer aspects is by looking at past performance data.  By that I mean looking at how various investment options have performed, and how various strategies have performed, in an attempt to find the answer to the question: realistically speaking, what’s the worst that can happen?  In this context, there is a quote attributed to former investment manager, Edmond Warner OBE, that is worth mentioning: “History never repeats itself exactly, but you owe it to yourself to be acquainted with the bear markets of yesteryear. At least if history does then repeat itself you can't say that you weren't warned.”

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