In the context of any investment product and specifically mutual funds, we often use the term ‘risk’. Risk acquires different meanings to different people. They also assign such meaning differently for different products. For example, risk to a 25-year old may connote higher returns for risk. Risk , to a 60-year old could mean possibility of losing money.
Understanding what risk really is and where it arises from is important for choosing the right product. Right product means one which suits your requirements. You also need to be prepared to handle risks associated with them. So let us try to understand more about the nature of risk involved in both equity and debt securities.
What is risk
Risk essentially means uncertainty of outcome. When you expect something to happen, but are not certain of its occurrence, if you still go ahead and put your time/effort/money there, you are taking a risk.
Take this simple example. When you go for a swim, you are not certain you will come out. There’s a chance, no matter how small, that you might drown. But you still go for a swim. By doing so, you are taking a risk.
Why people take risks
The psychological aspects of risk-taking behaviours are outside the scope of this article. However, to put it simply, individuals take risk primarily for two reasons. First is the thrill of it. Certain activities may involve considerable risk. But the thrill and joy of those experiences make them irresistible. Examples may be trekking, paragliding, etc. In such cases, we usually mitigate the risk by having an expert guide us.
The second reason for taking risk is the expectation of greater rewards. Take for example, taking swimming lessons. It is considerably risky as you are getting into the water when you can’t swim. But the reward is high. If successful, you will learn swimming and will forever feel safer in water.
When does risk arise
Risk arises when the outcome of any activity cannot be guaranteed. Take an election for example. Parties contesting the election are taking risk because none of them know the outcome. If there were just one party, the outcome would be known and hence there would be no risk.
Risk related to financial products
If you are wondering why I am talking of everything other than financial risk, it is because financial risk is not all that different from risks in other walks of life. Financial risk also involves uncertainty in the outcome of a business activity.
When you invest money, it invariably goes to a business activity (most of it, at least). There are primarily two ways to invest money in a business:
- invest directly in the business and participate in its gains or losses
- lend it for a fixed rate of return
The first is what you do when you buy shares of a company. In such a case, you are participating in the business. The second one, lending to a business, can be done by buying debentures issued by the company. In this case, your returns will be fixed and regular, subject to the capability of the business to pay you back.
Risk in ploughing your money in a business/company
It is common knowledge that businesses are risky. The outcome of any business cannot be guaranteed. One cannot say how many units will a company sell or at what prices over the next few years. One cannot predict movements in prices of raw materials. There is no way to predict the impact the entry of a new competitor may have. There also risks from geopolitical shifts, regulatory changes, labour unrest, etc.
Well established companies like Nokia, HUL and Airtel can be shaken up by new entrants. Even the biggest of enterprises are not entirely safe. So it is not difficult to understand why directly investing in a business can be risky.
However, the risk involved in lending is trickier to understand. Why is lending risky when the returns are fixed?
Risk in lending to a business
Lending is risky because the fundamental nature of business is such that it doesn’t preclude the possibility of the businesses completely failing to honour any of their obligations. If a business fails, the company is liable to pay back its lenders from its assets. But if its assets are not sufficient to make such payment, it will not pay back.
So even though interest is fixed it will be paid back only till the business is in good shape. The possibility of a default always exists. Just to note, not all defaults mean that the business is failing. It might be a temporary issue that the business can resolve and pay the interest later.
Credit risk: So now you know why lending can be risky as well. But can all loans be equally risky? Take a company like Reliance Industries, which has been in business for over 40 years, or Tata steel which has existed for over a 100 years. These are good companies, large companies, well established companies. We may think none of these are going to fail any time soon.
But can intuition serve this purpose for all businesses? Many smaller companies are not well known. That is where credit rating agencies come in. Credit rating agencies like Crisil, ICRA and CARE evaluate businesses and rate their bonds. These agencies have a lot of information about the businesses they rate. They look at the financial statements of these businesses, talk to their management, get additional information as required, and only then they assign ratings. The ratings are a good way to know how reliable the company, or a specific paper, is. Typically, ratings are given as AAA, AA+, AA, AA-, A, and so on. Higher the rating, lower the risk of default.
Duration risk: Now we know that some companies might not be as fundamentally strong as Reliance or Tata Steel. But a business which is seemingly doing well today, can’t suddenly fail tomorrow. Tomorrow is more certain than day after, which is more certain than the next week, which is more certain than the next month, and so on.
To put it simply, uncertainty increases with time-frame. You can be reasonably certain of how a business is going to perform in the next 3–6 months, given sufficient information. But predicting the long term performance will be difficult. How do you know what the company, or the economy, will be doing 8 years from today? Hence risk is higher when you are lending for a longer period and lower when lent for a shorter period.
How to reduce the risk
How do you deal with these risks? One way is to assess your risk with elaborate questionnaires. A simpler and practical way is to choose products based on your time frame of investing. When it comes to equity, short-term is risky. It is that simple. In the short term the speculation on what is to happen is higher and that leads to volatility in the stock. In the long term, when the company or business proves its growth potential, this risk reduces. Hence equity should be bought only if you have a long time frame.
The point of no loss is actually 7 years and above in equities, based on past returns. However, you can further reduce this risk by investing in the market systematically, thus not timing the market and allowing units to be averaged in short-term volatility. And even for the long term the risk in equity can be hedged by introducing debt in your portfolio.
Debt returns vary by time frame. Shorter term debt usually carries lower risk than longer term risk. If you choose longer term debt product, trying to exit them in shorter time frames can hurt you.
The other way to reduce risk is to take guidance.
As hinted in the trekking example, taking guidance from an expert can reduce risk. The same can be done for your investments as well. With mutual funds, fund managers do the expert job of managing your portfolio. And in the choice of funds, your advisors can help choose the fund fitting your time frame and risk profile. How much of equity and debt to hold and in what funds to hold will decide how well you manage your risks to building wealth.