Understanding investment risks

Piggy Bank on Rope.  

Inflation, taxes, government policies, geo-political situations and economic cycles affect all investments. These risks exist in the system. There is no way we can avoid them. Inflation will reduce the real (actual) rate of return from all forms of investment, be it debt or equity or property.

Similarly, taxes eat into the final returns in the hands of an investor. We have touched upon the kinds of risks earlier in this space but here is a detailed look at the hard realities.

In a Communist economy, wealth creation is difficult, irrespective of the risk-taking abilities of an individual. Likewise, if a local currency is revalued, all forms of investments will get impacted. The risk that exists in the system is called ‘systematic risk’.

There is absolutely no way to avoid systematic risk. However, by adopting time averaging (popularly known as systematic investment plans) one can reduce the impact of systematic risk. The impact of risk is averaged out by investing fixed amounts at fixed intervals.

Since more investment units will be bought at a lower cost and less investment units at a higher cost, over a prolonged period, averaging will start working in the investor’s favour. Please note that these investments could be in any class of asset.

It could be in debt, equity or property. Another strategy, which is superior to time averaging is value averaging. However, due to its complexity, it is usually not only recommended. The recurring bank deposit is also an example of a systematic investment plan.

Another category of risk is ‘unsystematic risk’. Risk which does not exist in the system as a whole but which is specific to a particular asset class or particular investment product is called unsystematic risk. Another name for unsystematic risk is ‘specific risk’.

Crashing of property prices in Mumbai due to an unfavourable court judgment on a development near the Arabian Sea is an example of unsystematic risk. This will only affect property prices in Mumbai, and no other form of investment in Mumbai or any other part of the world will be affected. Similarly, if the CEO of a company resigns, causing the stock price to tumble, then it is called an unsystematic risk.

This will have no impact on the prices of other stocks or any other investments. Another example could be of gold prices crashing due to government control.

Diversification is the best solution for controlling unsystematic risks. Diversification has different meanings to different investors. There are some who invest in six different floating rate schemes of mutual funds and feel that they have diversified their portfolio.

Others feel that by investing in different stocks, they have diversified their portfolio; so, for instance, they may own stocks of HLL, Marico Industries, Gillette India and P&G. A closer look will tell you that all these are FMCG stocks. Yet, there are a few who diversify through different investment vehicles; they may have mutual fund schemes, which invest in equity.

Diversification means investing in asset classes which have a negative correlation to each other. To put it simply, when the performance of one asset class usually goes up while the performance of the other asset class falls, they are negatively correlated.

This will ensure that the overall portfolio returns remain stable. If the explanation has to be further diluted, we would say, “do not place all your eggs in one basket”. By diversifying a portfolio, unsystematic risks are significantly reduced.

There can never ever be a risk-free return. Risk-free returns do not

In fact, a return is solely a factor of risk. However, a proper understanding of risk will assist in generating higher returns with the same amount of risk.

(The writer is a financial planner & author of Yogic Wealth)

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Printable version | Oct 19, 2021 3:34:11 PM |

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