Risk-return: two sides of a coin

You can’t have one without the other. Hence, understand the risks involved in various investments to maximise returns.

People aren’t risk-averse; they're loss-averse. Usually, occurrence of loss is more painful than happiness from gain / profit. The pain on losing Rs 50,000 is much more than the happiness in gaining the same amount.

Similarly, when people say they want to take high risk, what is going on in their mind is ‘high risk, high return’. At that stage, the probability of a loss is almost absent in their mind. People tend to forget that loss (read: risk) is an integral part of any form of investment. An investor who understands different kinds of risk and their characteristics will have a much more stable portfolio than one who invests haphazardly.

There are mainly two kinds of risk for any form of investment anywhere in the world, systematic and unsystematic. This is what they mean:

Systematic risk exists in the economic system. For example, inflation, government policies, consumer confidence, and so on. These adversely impact all forms of investment. Inflation, for instance, will always reduce the real rate of return of all forms of investment. Unfortunately, we cannot diversify away from systematic risk. Whether we buy equity, debt or real estate or any other form of asset to diversify our portfolio, systematic risk will always impact the returns.

One strategy that can be adopted to tackle systematic risk is rupee cost averaging. If we keep investing a fixed amount at a fixed interval, over a period of time, our purchase value of investment will start averaging (unless it is a unidirectional falling market for a prolonged period.) This happens because the level and constituents of systematic risk keep varying. Many mutual funds offer systematic investment plans, the best way to invest in markets.

Unsystematic risk is associated with only a particular kind of investment vehicle or instrument. For instance, by investing only in Infosys, we get exposed to unsystematic risk. Any adverse outcome will impact the performance of the company. Similarly, if a majority of investment is in real estate and if the government’s policies on real estate change, there could be an adverse impact on the portfolio.

To reduce the impact of unsystematic risk, one should diversify the portfolio. Unfortunately, different people understand diversification differently. To some, investing in fixed deposits (FDs) of different banks is diversification. There are others who invest in similar styles of schemes of different mutual fund companies. Like a portfolio where an individual had invested in nine different gilt funds of different mutual fund houses. There are still others who will have eight to ten stocks of different pharmaceutical companies. None of these can be called diversification. If the government was to change the tax rate on FDs, for instance, it would universally impact all FD investments. Similarly, all pharmaceutical companies would get impacted due to a change of policy impinging on the sector.

Diversification means investing in those classes of assets which move in opposite directions. Statistically, it is called negative correlation. Usually (though, not always), debt and equity markets have negative correlation. In the year 2008 and 2009, equity markets performed poorly. In those years, debt markets (debt funds) gave exceptionally good returns. In the recent past, debt has been giving (lower) returns but equity has performed well. An individual with only equity in his portfolio would have had disastrous years in 2008 and 2009 but extremely good years in 2009 and 2010. His / her portfolio would have been extremely volatile. Compared to this, someone with a diversified portfolio consisting of both debt and equity would have had stable returns.

An expert investor is not one who generates a phenomenal return in a few years and poor returns in the other. What is needed is stable growth of the portfolio over a prolonged period of time. This can happen by generating optimal risk-adjusted returns. And by remembering at all times that risk is an integral part of all our investments.