PUTTING RISK IN PERSPECTIVE

Source: The Hitavada      Date: 12 Mar 2018 11:21:22


 

One of the primary aims of the investor is to ensure that the invested capital remains reasonably safe. We are using the word ‘reasonably’ and not ‘absolutely’ with a very good purpose. A prudent investor realises the truth behind the dictum ‘nothing risked, nothing gained’. Every time he opts for safety, he pays a price for this safety. The difference between the interest he would have earned and he actually earns is the insurance premium he pays to play safe.

Insurance against contingencies is, in general, a very wise policy. If one unwisely opts for higher interest and consequently invests all his life-savings in a weak company and if the company goes into liquidation, he loses not only the savings but also the steady income in terms of interest that he would have received.
However, when this fear weighs so much on the mind, that one ends up over protecting oneself, it often ends up worse than no protection at all. At all times, you must weigh the cost of this safety against its benefit whenever you take a financial decision.
Let us have a good look at this aspect through the
following example.
Mr A and Mr B each have Rs 1 lakh available for investment. Mr A plays safe and invests @ 7.25 per cent p.a. However, Mr. B carefully studies all opportunities available and, not wishing to put all eggs in one basket, invests Rs 5,000 each, at 20 different places giving him an average yield of 11.20 per cent pa. Why have we chosen 7.25 per cent and 11.20 per cent for comparison? We will answer this a little later. Mr B watches his investments continuously and changes scrips whenever he feels that a particular company is not faring well. In spite of all these precautions, he is very unlucky. Every year one of the companies goes into liquidation and he loses not only his capital of Rs 5,000 per year (= entire capital of Rs 100,000 during 20 years) but also all the future dividends he would have earned thereon. Nevertheless, he persists in his policy and re-invests all funds generated by his investments in similar ventures getting 11.20 per cent returns but losing Rs 5,000 per year.


After a period of 20 years, they compare how their investments have fared. The following table works out the value arising out of original capital. It is found that Mr A’s capital has grown to Rs 405,458 whereas Mr B’s capital has grown to Rs 507,311, higher than that of Mr A by Rs 101,853! If none of the companies had gone into liquidation, Mr B’s Capital would have been Rs 835,787, more than double of Mr A’s capital.


Now, you decide whether you would like to adopt the financial philosophy of Mr A or Mr B Before deciding we would like you to know that the interest rate of 7.25 per cent is the highest current rate that is available on a nationalised bank FD (very safe and guaranteed) whereas 11.20 per cent is five year rate of returns on a long term income scheme from a public sector mutual fund. Of course, mutual funds are subject to market risks.
Incidentally, if you look at the table you will realise that if Mr B had got scared and moved over to the safe FDs, before 10 years, he would have been a loser. This very Table strongly proves that long-term view is always well rewarded.


When an investment is lost, there is a visible loss. When the investor rejects an opportunity to invest at higher rate, there is an invisible loss. Both the visible as well as the invisible losses have identical resultant influence on your finances. A prudent investment policy should strike a balance between these losses. An investor who does not have a good assessment of realistic power of money to earn more money tends to be overcautious without realising the opportunity cost involved.


We have given the above example, not with an intention to suggest that one should gamble or speculate. I only wish to assert that it is necessary to take calculated risks. The line between the two is very thin indeed but a better understanding of ‘how money grows’ enables one to take better investment decisions.Money is like an organism. It grows into a colony when it is given the right environment, without which however, it withers away.


Incidentally, Gilt-based schemes are safer than other debt-based schemes and the debt-based ones are safer than equity-based schemes. Moreover, it is true that any scheme (including equity-based) of any MF has not gone into liquidation over the last 20 years. We have assumed a loss of Rs 5,000 per year, only to highlight the correct concept of risk.At End: It is our personal opinion that the diktat of declaring, “Mutual Funds are subject to market risks” has scared many investors away from MFs. Many of them have gone over to ULIPs of insurers which is a comparable product but there is no such diktat. Regulators of comparable products should come together and arrive at a common code of conduct/ best practices so that investors are not misinformed on account of the differing processes and practices of each. (The authors may be contacted at [email protected]) l