Protecting the principal thus cannot be a reasonable objective for an investor, unless it is for the short term. A person who wants protect the principal for making a house down payment after 5 months, wanting to buy a bike after 3 months, who has her daughter to be married off in the next 4 months, who has elderly sick parents are all justified in keeping their money safe as the requirement for them to make use of their money could arise at any time.
As a country, India is averse to risk. Keeping the principal safe is by itself an objective for many an ‘investor’. Any ‘investment’ scheme with a ‘guarantee’ of returns however less it may be is a sure shot seller in our financial markets.
What is risk?
Risk is any deviation from expectation. Unfortunately it is not an absolute measure when compared between 2 different people. For one who expects a return of 8% and actually gets 7% there is a risk. For a person who expects 24% and gets 21% there is the same risk. It does not matter that there is a threefold difference in absolute terms (3 x 8 =24; 3 x 7 =21).
This brings in confusion to investors’ minds because they see only the absolute values. A person who expects 8% thinks that he is taking a low risk and so his expectations have to be met more than a person who expects 28%. But the game of investing has a different set of rules.
The person who expected 8% and ended up at 7% may in reality be a far greater loser.
Forms of risk
Investors have to face risk in different forms like interest rate risk, reinvestment risk, trading risk, inflation risk, market risk and company risk. Each of these risks has its own ways of action on the investor. Based on the risk that is operating currently an investor may have to switch their funds between different investment tools.
For example, an investor who only wants to preserve the capital (principal) faces inflation risk. If the investor saves Rs.1 lakh and also ensures that the 1 lakh is safe always by earning a 7.75% interest rate (by investing in a bank deposit today), he/she is losing money at close to 2-3% because the inflation is at close to 10% overall (not to frighten the investor with the food items inflation which is above 15%).
Protecting the principal thus cannot be a reasonable objective for an investor, unless it is for the short term. A person who wants protect the principal for making a house down payment after 5 months, wanting to buy a bike after 3 months, who has her daughter to be married off in the next 4 months, who has elderly sick parents are all justified in keeping their money safe as the requirement for them to make use of their money could arise at any time.
Is taking high risk equal to getting high returns?
No way. Ask any person who has gambled and lost his/her money. Taking high risk does not guarantee high returns.
But the opposite is true – if one wants high returns the risk taken has to be higher. Here is where the concept of diversification helps us. Diversification is the age old advice of not putting all our eggs in the same basket. By making investments in different asset classes like land and building, equity mutual funds and ULIPs, one could plan for the long term. For the short term one can diversify across bank deposits, company deposits and debt mutual funds. 5 to 10% of one’s assets (excluding real estate) can be in gold and silver (not jewellery) to hedge against inflation.
Regular investments
By going for a regular and planned investment on a monthly, weekly or fortnightly basis, the vagaries of the market can be overcome. This concept is called Cost Averaging. By investing in an equity mutual fund for example a regular amount of say Rs.1000/- one does not have to bother about the fluctuation in the market due to a Government change, or global downturn or a stock market scam, or war in any part of the world or a major policy change by the Government.
The reason is that when the equity market is going down, the investment of Rs.1000/- buys more mutual fund units and when the market is going up the value of all the units grow. This makes regular investment a winner when the market goes down and also when the market goes up.
Time is the solution not timing
To time the market for making a right investment is difficult and is in fact the Trillion Dollar question. But by allowing time to work in one’s favour one is always a winner. It is a proven fact for our stock market that over any 5 years period there is always a return much greater than the bank deposit rate in that period. This is including the 5 year period ending during the peak of the global melt down during 2008-2009.
Risk is a mind game
For one to make use of time, to get better return, one has to have the tenacity to keep investing the Rs.1000/- even when the market is going down. One should not be pressured by peers who are shouting about their losses and asking to put the money out when at least the ‘principal is safe’.
At the same time one has to have the mental maturity to identity and accept that one has made a wrong choice when an investment has not given expected returns for a longtime. To make good the loss one has made in an investment from the same investment is difficult in the investment game. One has to learn from the mistakes and move on.
Risk taking in India
The quantum of bank deposits in India is a whopping Rs.41 lakh crores. In comparison the quantum invested by Indians in equity oriented mutual funds is a mere Rs.2 lakh crores. The numbers say a lot about our risk taking and our expectations in terms of returns. It is time to start investing in different investment avenues for different purposes than to use the bank deposit as the sole investment tool for all purposes.