As an investor your objective
is simple — maximise returns and minimise risks. The first part
of the equation, the return, is relatively easy to understand. It
is objective in nature, in as much as, when you undertake an investment,
you have a fairly good idea as to what the return is going to be.
It is quantifiable as it is a number.
However, what about risk? How do you quantify it? How do you minimise
it? How do you achieve the fine balance required between risk and
return to optimise your investment consistent with your goals?
Well, let us begin with understanding the concept of risk and how
it differs for various instruments.
The one thing that almost all investors would agree upon is the fact
that equity is definitely more risky than debt. 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 the overall interest rates in
the economy rise, the prices of fixed income earning instruments
fall and vice versa. Interest rates in the economy may fluctuate
due to several factors such as a change in the RBI’s monetary
policy, CRR requirements, Forex reserves, the level of the fiscal
deficit and the consequent inflation outlook.
Then there are the event-based factors that affect interest rates,
for instance, September 11 episode, USA and December 13, India.
If there is 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 the returns,
let us take the example of MFs. Adjusting the portfolio to the market
rate of returns is called “marking to market.”
We assume that the current NAV of the MF is Rs 10 and its corpus
is Rs 1,000 crores. This means that if the fund sells all the assets
of the scheme and distributes the money on equitable basis to all
the 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 the existing investors. Therefore, something
has got to be done to protect their interest.
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, the NAV rises when the interest falls.
Credit Risk
This is the risk of default. What if the company whose FD you invested
in goes bankrupt? True,
you have legal remedy, but everyone knows how much time our courts
take.
The only factor, which dilutes this risk somewhat, is the 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; you have
to be on the lookout for the same. A case in point is the recent
BPL whose rating was downgraded from ‘A+’ directly to
‘D’, the default grade! 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. The credit risk can be simply eliminated
by investing in sovereign securities — securities issued by
the government. There is simply no risk of default.For retail investors,
Interest rate risk discussed earlier 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 PPF, 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 that has reared its ugly head in recent
times. In the previous paragraph it is mentioned, “the interest
rate risk is eliminated by simply holding the instruments till maturity.”
However, such principles of investment had not contended with unilateral
governmental action. For example, the authorities have consistently
reduced the rates of PPF, over the past three years, from 12% p.a.
to 9% p.a. Relief Bonds have come down to 8%. Rates on other small
saving instruments have also been slashed across the board.
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 the 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. Next time we shall touch upon these basics of Modern Portfolio
Theory that enable you as an investor to actually quantify the risk
existing in the investment you are contemplating.
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