A four-letter word called risk

The Sensex has touched 13,700. While on the one hand, investors are ecstatic, at the back of their mind, everyone would be asking one question. Is the market too risky? Have the valuations climbed too fast, too soon? Are further investments riskier?  

Let’s take one step back and understand what the word ‘risk’ signify. What’s risk? How do you quantify it? How do you minimise it? How do you achieve the fine balance between risks and returns to optimise your investments?

Let’s begin with understanding risk and its various facets.

Systematic risk

Systematic Risk is the risk inherent in the economic system. Macro factors such as domestic as well as international policies, employment rate, the rate and momentum of inflation and general level of consumer confidence etc are what constitute this risk. Generally, investors cannot hedge or diversify against this risk as it affects all kinds of asset classes and affects the entire economy.

Unsystematic risk

This is the risk inherent in a particular asset class. The best way to fight this is through diversification. However, one must remember that diversification must be in the class of asset and not the asset itself. An example is evenly distributing your portfolio in bank deposits, RBI bonds, real estate and equities. That way, if a certain unsystematic risk — let’s say a crash in real estate prices — happens, then the presence of other classes of assets in your portfolio saves you from a total washout. However, diversifying within the same asset class (buying different equity shares) is not strictly combating unsystematic risk.

Understanding unsystematic risk

One thing that almost all investors would agree is that equity is definitely riskier than debt. Irrational exuberance with a rising market has left many investors losing their shirts, and in some cases, even more sensitive garments.

However, does this mean that investing in debt instruments is entirely risk-free? Unfortunately, the answer is in the negative, though the volatility is much less. So first, let us examine what kind of risks do debt instruments pose.

Interest rate risk

Interest rates and prices of fixed-income instruments share an inverse relationship. In other words, when overall interest rates in the economy rise, prices of fixed-income earning instruments fall and vice-versa.

Interest rates in the economy may fluctuate on several factors like a change in the RBI’s monetary policy, CRR requirements, forex reserves, the level of the fiscal deficit and the consequent inflation outlook etc. Extraneous factors such as energy price fluctuations, commodity demand and supply and even capital flows may result in rates fluctuating.

Then, there are event-based factors that affect interest rates. For example, the 11/9 episode in the US. If there’s a war, interest rates will rise. However, typically such events are temporary in nature and, in fact, a good fund manager can actually take advantage of such hiccups.

To illustrate how fluctuations in interest rates affect returns, let’s take the example of mutual funds (MFs). Adjusting the portfolio to the market rate of returns is called ‘marking to market’.

Let’s assume that the current net asset value (NAV) an MF scheme is Rs 10 and its corpus is Rs 1,000 crore. This means that if the fund sells all the assets of the scheme and distributes the money on an equitable basis to all unit holders, they will receive Rs 10 per unit. Now suppose the interest rate falls from 10% to 9%. Immediately thereafter, you wish to invest Rs 1 lakh in the scheme. Realise that the entire corpus of the fund stands invested at an average return of 10%. If the fund sells the units to you at its current NAV of Rs 10, you will be allotted 10,000 units.

This will benefit you immensely. You will be a partner in sharing the benefit of the higher returns of 10%, though the fund will be forced to invest your Rs 1 lakh at the lower rate of 9%.  This is injustice to existing investors. Therefore, something has to be done to protect their interests.

Here comes the ‘mark to market’ concept. The fund raises its NAV to Rs 11.11. You will be allotted only 9,000 units and not 10,000. The returns on 9,000 units @10% would be identical with the returns on 10,000 units @9%.

In other words, NAV rises when interest rate falls.

Credit risk

This is the risk of default. What if the company whose FD you invested in goes bankrupt? There have already been several such cases. Deposits with plantation companies and time share resorts are cases in point. True, you have legal recourses, but everyone knows how much time our courts take.

The only factor which somewhat dilutes this risk is credit rating. Fixed-income earning instruments get rated for varying degrees of safety. Investing in a highly rated instrument is safe but not sufficient. Firstly, the instrument may be downgraded. Then there have been cases where the issuer has got rated by different agencies but chooses to indicate only the higher ones.

Elimination of risks

There is some good news though. Credit risk can be simply eliminated by investing in sovereign securities — securities issued by the government. There is simply no risk of default. Or, so we hope. For retail investors, MFs offer gilt schemes where almost the entire corpus is invested in sovereign securities thereby achieving the same result.

Interest-rate risks is always prevalent. However, it comes into play only when a transaction is undertaken during the pendancy of the fixed-income instrument. Ergo, it follows that if the investment is held till maturity, there would be no interest-rate risk.

Investments such as Public Provident Fund, Relief Bonds etc are normally held till maturity. These are examples where both the risks inherent in debt instruments are at a bare minimum.

Government action risk

This is a unique kind of risk which has reared its ugly head in recent times. In the previous para, it is mentioned that the interest-rate risk is eliminated by simply holding the instrument till maturity. However, such principles of investment had not contended unilateral governmental action. For example, the rates of PPF over the past three years have been consistently reduced by the authorities from 12% p.a. to 8% p.a. To add insult to injury, these rates are applicable on the entire corpus and not on additional investment. Relief bonds have come down to 8%. Rates on other small saving instruments have also been slashed across the board.  Unfortunately, there is no escape from this risk —- that of our government!

Measuring risk

So far, we have acquainted ourselves with the kinds of risks inherent in investment instruments. However, merely knowing this much may not be enough to take an informed decision. The article began with the premise that return is objective since it is quantifiable. Then, can we not try and quantify risk? Well, age old statistical tools like standard deviation and regression help us do precisely that. In the nest article, we shall touch upon these basics of Modern Portfolio Theory, which enables you as an investor to actually quantify the risk in an investment.

To be concluded

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