Investing: How to tackle risks

Mention investments to an investor and there's a fair chance that he will respond by asking you what kind of returns the investment will yield.

While investments and returns are inextricably linked, there is another aspect (and a rather vital one) to investments that often escapes the investor's attention – the risk involved. In fact even the returns generated by an investment avenue are a factor of the risk borne.

A basic tenet of investing suggests that risk and return are directly correlated i.e. higher the risk borne, higher are the returns expected. A closer scrutiny of assured return avenues like fixed deposits and National Savings Certificate (NSC) vis-à-vis market-linked avenues like equities and equity funds will help us better understand the risk-return trade off.

In avenues like fixed deposits and NSC wherein the returns are assured and known at the time of investment, the investor doesn't take on any risk. Expectedly the returns on these avenues are modest as compared to high risk avenues like equity funds and equities. For example at present, a 6-Yr fixed deposit with an "AAA" rating (signifying highest safety levels) earns a return of 7.75% per annum. Similarly, an investment in NSC (which is backed by a Government of India guarantee), yields a return of 8% per annum over the 6-Yr investment tenure.

Conversely, the risk levels associated with avenues like equities and equity funds are much higher since the returns are not assured. Unlike assured return schemes, wherein the investor's capital is protected and returns assured, investors in market-linked avenues run the risk of losing their capital. The compensation for the risk borne comes in the form of potentially higher returns. The table below lists the top-performing schemes from the diversified equity funds over a 5-Yr time frame.

Leading diversified equity funds

(Source: Credence Analytics. NAV data as on July 26, 2006. Growth over 1-Yr is compounded annualised)

Investors in fixed deposits and NSC, five years ago would have seen their investments grow by approximately 9.00%-9.50% per annum over the investment tenure. Evidently, investors in the diversified equity funds have clocked superior performances over the same time frame.

The differential between the returns earned by fixed income investors and those earned by equity fund investors must be seen as a reward for the latter for their willingness to invest in a market-linked investment avenue. Of course, investors must not ignore the fact that over longer time frames, equities have shown the potential to outperform other assets like bonds and fixed deposits. I

nvestors are rewarded when they are willing to invest in this potential in the hope of clocking actual returns knowing that they could risk losing their capital in the interim.

Sadly, this seemingly simple concept tends to get distorted in a rising market scenario. When the equity markets hit a purple patch (as they did from 2004 – mid 2006), making money on the markets seems like an easy task.

The keyword here is "seems". The rising markets notwithstanding, the risk profile of market-linked investments remains unchanged. Hence equity funds continue to high-risk avenues, irrespective of whether the markets are experiencing a bull run or otherwise.

However greed coupled with the temptation to ride the bull run and make a quick gain often forces investors to throw caution to the winds and get invested in investment avenues which don't suit their risk appetite. Often, investment advisors also act as "partners in crime".

Sales pitches like "a fixed deposit investment will deliver a growth of 8% over 1 year, you can earn much more in a few months by investing in mutual funds" are rather common.

The dynamics of investing in assured return schemes and market-linked avenues are as similar as chalk and cheese. While the possibility of clocking impressive returns by investing in market-linked avenues like mutual funds cannot be ruled out, the commensurately higher risk levels (which could entail losing the capital invested in the course of a downturn in markets) shouldn't be ignored.

Our advice to investors – always invest in line with your risk appetite irrespective of the market conditions. Your risk appetite remains unchanged regardless of how the markets are placed.

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