The risk-return tradeoff

Anup Menon

TRADITIONAL wisdom on the risk-return relationship is that the greater the risk
associated with an investment, the higher should be the compensation -- otherwise
described as the risk premium.

An investment decision should, thus, depend primarily on the returns realised after
taking into account the risk. This can be assessed using an indicator of the returns
expressed as a unit of risk. The actual number is arrived at by dividing the returns by
the variation in returns as measured by the standard deviation of the returns.

Business Line analysed the returns per unit of risk on the Nifty stocks on monthly,
quarterly, half-yearly and yearly basis. On an absolute return basis, 20 stocks posted
positive average annual returns above the average bank deposit rate of 10 per cent.
However, after adjusting for risks, only 12 provided returns over the average bank
deposit rate. The best performers, post-adjustment for risk, include FMCG and
technology players.

An interesting trend that emerged from the returns per unit of risk analysis was that
some of the leading FMCG companies, such as HLL, Britannia, Nestle and ITC,
performed well, over the last seven years. Historically, FMCG stocks had lower
volatility than some of the fancied sectors.

This is a positive factor for investors in times of volatility. A portfolio of FMCG stocks
loses value during periods of volatility at a much lower rate than a portfolio of non-
FMCG stocks. This is a fundamental difference between investing in technology and
FMCG stocks.

Both the technology and FMCG sectors posted fairly good returns over the seven-
year period. However, the risks associated with the former is higher than that for the
latter. The reason is fairly simple. Because of the evolutionary nature of the
business, the perception of value of technology businesses and the premium
associated with companies in this sector vary among market players.

This uncertainty induced by changing perceptions leads to higher risk, as reflected in

the price movements. This is evident from the fact that HCL Infosystems and Satyam
Computers have monthly return volatility levels of 3.51 per cent and 3.80 per cent
respectively.

Compared to this, the FMCG stocks have a lower level of volatility. The reasons could
be that the market understands the business of these companies better than it does
that of technology firms. Even historically, FMCG stocks have recorded good returns,
making them good defensive plays. Consequently, these stocks may be viewed more
as defensive stocks, leading to lower speculation in the market. Hence, prices tend to
be more stable.

This is evidenced by the fact that Nestle and Britannia have risk levels on monthly
returns of 1.71 per cent and 1.41 per cent. Further, the risk level of the FMCG giant,
HLL, is around 1.80 per cent, close to the index volatility level of 2 per cent. Hence,
HLL may be a good proxy for the index per se.

The only major in the FMCG sector to have registered significant losses is Colgate
Palmolive. The company has been losing market share to HLL over the last few
years. Its poor price performance can be attributed to this. At the same time, its risk
level is close to HLL's.

Click here for Table

Safe options

Among all investment avenues, equity is the riskiest. Theoretically, there is a

possibility that at times when the equity market volatility is high, most stocks are
going through a volatile phase. This may lead to some investors moving from the
high-risk equity class to the lower-risk bonds and bank deposits. In mid-1998, for
instance, when the equity market was being hammered down, many investors
moved to such safer options treasury bonds.

Click here for Table

India does not have a deep debt market. Most investments in debt securities are
likely to be in bank deposits and fixed deposits of manufacturing companies. For
instance, the fixed deposit programme of Tata Power, an index-based stock, offers a
yearly rate of return of around 11 per cent.

However, over the last seven years, the company's equity returns have been lower
than 5 per cent. It goes to show that, in some cases, especially Old Economy stocks,
investors may be better off investing in debt than in equity.

Taking a more conservative position, an analysis of the number of stocks that

recorded an average annual return greater than the bank deposit rates indicates that
only 20 managed to post positive returns. One has to consider the fact that the
average bank rate may have been conservative, given the higher interest rates
prevailing in the market before 1999. Overall, the indications are that a long-term
investment in the equity market may not pay off.
Given these market conditions, a 20 per cent average annual return on equity
investments would be an acceptable benchmark. But based on these criteria, only 13
stocks managed to post higher returns on an annualised basis. Among the bluechips
that did not make the positive list are ICICI, Larsen and Toubro, Reliance Industries
and Tata group companies.

Significantly, a majority of the bluechip stocks in the negative territory were from the
economically-sensitive sector. This trend is likely to continue given the general
market trends and the current preferences of the institutional investors.
Risk and Return Analysis

Return expresses the amount which an investor actually earned on an investment during a
certain period. Return includes the interest, dividend and capital gains; while risk represents the
uncertainty associated with a particular task. In financial terms, risk is the chance or probability
that a certain investment may or may not deliver the actual/expected returns.

The risk and return trade off says that the potential return rises with an increase in risk. It is
important for an investor to decide on a balance between the desire for the lowest possible risk
and highest possible return.

Risk Analysis

Risk in investment exists because of the inability to make perfect or accurate forecasts. Risk in
investment is defined as the variability that is likely to occur in future cash flows from an
investment. The greater variability of these cash flows indicates greater risk.

Variance or standard deviation measures the deviation about expected cash flows of each of the
possible cash flows and is known as the absolute measure of risk; while co-efficient of variation is
a relative measure of risk.

For carrying out risk analysis, following methods are used-

• Payback [How long will it take to recover the investment]

• Certainty equivalent [The amount that will certainly come to you]
• Risk adjusted discount rate [Present value i.e. PV of future inflows with discount rate]

However in practice, sensitivity analysis and conservative forecast techniques being simpler and
easier to handle, are used for risk analysis. Sensitivity analysis [a variation of break even
analysis] allows estimating the impact of change in the behavior of critical variables on the
investment cash flows. Conservative forecasts include using short payback or higher discount
rates for discounting cash flows.

Investment Risks

Investment risk is related to the probability of earning a low or negative actual return as compared
to the return that is estimated. There are 2 types of investments risks:

1. Stand-alone risk

This risk is associated with a single asset, meaning that the risk will cease to exist if that
particular asset is not held. The impact of stand alone risk can be mitigated by
diversifying the portfolio.

Stand-alone risk = Market risk + Firm specific risk

Where,

o Market risk is a portion of the security's stand-alone risk that cannot be

eliminated trough diversification and it is measured by beta
 o Firm risk is a portion of a security's stand-alone risk that can be eliminated
through proper diversification
2. Portfolio risk

This is the risk involved in a certain combination of assets in a portfolio which fails to
deliver the overall objective of the portfolio. Risk can be minimized but cannot be
eliminated, whether the portfolio is balanced or not. A balanced portfolio reduces risk
while a non-balanced portfolio increases risk.

Sources of risks

o Inflation
o Business cycle
o Interest rates
o Management
o Business risk
o Financial risk
Return Analysis

An investment is the current commitment of funds done in the expectation of earning greater
amount in future. Returns are subject to uncertainty or variance Longer the period of investment,
greater will be the returns sought. An investor will also like to ensure that the returns are greater
than the rate of inflation.

An investor will look forward to getting compensated by way of an expected return based on 3
factors -

• Risk involved
• Duration of investment [Time value of money]
• Expected price levels [Inflation]

The basic rate or time value of money is the real risk free rate [RRFR] which is free of any risk
premium and inflation. This rate generally remains stable; but in the long run there could be
gradual changes in the RRFR depending upon factors such as consumption trends, economic
growth and openness of the economy.

If we include the component of inflation into the RRFR without the risk premium, such a return will
be known as nominal risk free rate [NRFR]

NRFR = ( 1 + RRFR ) * ( 1 + expected rate of inflation ) - 1

Third component is the risk premium that represents all kinds of uncertainties and is calculated as
follows -

Expected return = NRFR + Risk premium

Risk and return trade off

Investors make investment with the objective of earning some tangible benefit. This benefit in
financial terminology is termed as return and is a reward for taking a specified amount of risk.

Risk is defined as the possibility of the actual return being different from the expected return on
an investment over the period of investment. Low risk leads to low returns. For instance, incase of
government securities, while the rate of return is low, the risk of defaulting is also low. High risks
lead to higher potential returns, but may also lead to higher losses. Long-term returns on stocks
are much higher than the returns on Government securities, but the risk of losing money is also
higher.

Rate of return on an investment cal be calculated using the following formula-

Return = (Amount received - Amount invested) / Amount invested

He risk and return trade off says that the potential rises with an increase in risk. An investor must
decide a balance between the desire for the lowest possible risk and highest possible return.
How to invest: the basic principles

Now that you have figured out why investing is a smart thing to do,
let's move on to – how to invest.

For a beginner investor its tough not to get overwhelmed -

market publications and websites are full of 5-star rated Mutual Funds, ULIPs that
promise the best of insurance and investment (but actually isn't), the lure of
momentum stocks that everyone at office seems to be making a quick buck on - hell,
just how and where does one start?

Relax. This 2 part series, on how to invest, will make life simpler.

First you will need to understand the relationship between risk and return, and the
associated trade-offs between the two. Next you will learn established ways of
mitigating such risks.

Equally important is to understand how your individual circumstances affect your

investment decisions. Your tolerance for risk (can you stomach a 10% temporary
loss), your return requirements (are you investing towards buying a house, or you
need some regular monthly income), your investment horizon (the time you can
remain invested), as also your tax status will impact decisions on what kinds of
investments to go for, and what to avoid.

The 2nd part of this series - how to invest: Your individual investment profile, will
address that.

So much for an overall picture on the how to invest decision making process. Let's
get started on the details.

First things first

Before we get going on return and risk principles and how to invest, we will first
need to talk a little bit on how to structure your financial life to make it possible to
invest.

When you start investing you must do so with a clean slate. There's no point in
trying to save while you have high-interest credit card or personal loan debts
accumulating by the day. Sure, some kind of debts can be low-interest or useful for
tax-saving purposes such as your housing-loan. But you will be well-advised to get
ready to close off your high interest debts, before you start thinking on how to
invest.

Next get into the habit of forced saving. You pay bills every month - electricity, to
mobile to cable bills, right. Just add yourself at the top of the list. Every month as
you get your salary credited to you account, set aside a sum to save or invest. Start
with a minimum of 20%. The more you save, the more wealth you can create. Even
a few rupees saved now will do more than lots of rupees saved later!
Understanding Return and Risk

At the core, understanding how to invest is all about returns and risk. Return is
measured by how much one's money has grown over the investment period. Returns
are not known in advance. Instead, you can only make an educated guess as to what
kind of return to expect.

Expecting a return of 25% just because your stock-investing friend say's that's what
you will make may be unreasonable. Most expectations are based on what's
happened in the past. Unfortunately history doesnt always repeat itself! We have all
seen the highs of 2007, followed by the lows in 2008, haven't we?

However we can draw reasonable conclusions about future returns by looking at

longer-term data - 5yr and 10yr records - ofcourse with the express understanding
that these returns are not guaranteed.

Even if your return expectations are reasonable, there is the possibility that your
actual returns turn out different than expected. You run the risk of losing some or all
of your original investment.

Why is that? Because of an uncertain future ( e.g. global economic environment),

uncertainity over the quality and stability of investment, and some other
uncertainities. In general, greater the uncertainity, greater the risk. Some common
sources of uncertainity or risks that we must absorb, while we learn how to invest,
are:

Business and Industry Risk

There might be a industry-wide slowdown, or even a global economic recession as
we are experiencing now. That presents an uncertain future for any business, isn't it.
Or the business might see its earnings dropping significantly say, due to
management ineptitude/wrong decisions. The lower earnings (due to any of the
above) may cause the companys stock to fall.

Inflation Risk
The money you earn today is always worth more than the same amount of money at
a future date. This is because goods and services usually cost more in the future,
due to inflation. So its important that your investment return beats the inflation rate.
If it merely keeps pace with inflation then your investment return is not worth much.
We have seen inflation soaring upto 11% in 2008, now in 2009 its at 1 or 2% levels.
Perhaps an average inflation rate over next 10 years may work out at 5-6%. Who
knows, there's enough uncertainity here too.

Market Risk
Market Risk is about the uncertainity faced in the stock market. Several macro and
micro economic details singularly or plurally can spook the market. We have seen
how the massive mandate in elections 2009 has re-invigorated the market. On the
other hand, A fragmented hung parliament may have caused the market to
nosedive? Even for a well-managed business growing profitably, its stock may drop
in value simply because the overall stock market has fallen.
Liquidity Risk
Sometimes you are not able to get out of your investment conveniently, and at a
reasonable price. For example in 2008, you may have found it tough to sell your
house at a price you wanted. In 2007 however you could have gone laughing to the
bank. The market may simply be inactive or it may be just volatile - and that means
you cant sell your investment or get the price you want, if you needed to sell
immediately.

Now here comes an important takeway in learning how to invest - understanding the
risks associated with different asset classes.

The degree of risk varies widely between asset classes and even among investment
options in a asset class. We all appreciate that a govt-backed bond like a NSC or PPF
scheme is safer than that offered by a reputed corporate. Next consider inflation risk
- stocks face far lesser inflation risk than bonds. While bonds have managed to just
keep pace with inflation, stocks have historically outpaced inflation, by some 10%
annually on an average in India. However short-term bonds and money market
investments face very little liquidity risk, while stocks face relatively greater liquidity
risk.

The risk return trade-off

The next important takeaway in learning how to invest, is understanding risk/return

analysis or trade-offs. Every investor would want the highest possible return for the
level of risk (uncertainity) that he is willing to accept. In a competitive marketplace,
this results in a trade-off. Low-risk investments naturally are associated with low
potential returns and high-risk investments with high potential returns.

If we look at long term returns, stocks in India have historically produced returns
that average 15% annually, while bonds have averaged 6-9% annually. This reflects
the risk/return trade-off.

Its important to remember that this is on an average for the asset class. Specific
investment options may produce far higher or lower returns. For example an
investment in ITC for the last 15 years has provided returns in excess of 30%
annually. It's useful to remember that the risk is in the uncertainity. If you can
evaluate a stock investment and weigh the potential returns with the uncertainities
(or, relative lack of uncertainity) vis-a-vis another stock investment, you stand to
gain tremendously from these trade-offs too!

There's another useful service these risk/return trade-offs serve. They flag off highly
risky investments. Any scheme advertising high potential returns usually flags high
risk, even though the risks may not be apparent at first glance. For example, quite
often we see Corporate Bonds offering far higher yields than usual (usually, from
unknown companies), don't we - now that you know how to invest basics and the
risk/return trade-offs, I am sure you will treat these with caution and a healthy dose
of skepticism!
Diversification: Mitigating Risks

Diversification is a strategy that can be neatly summed up by the timeless adage

"Don't put all your eggs in one basket." We have learnt how to invest, is all about
returns and risk principles. You will now probably look to invest in a stock only after
analysing that you will be compensated well (for the risk you are taking by investing
in the stock), from the stock's returns.

Now consider the scenario that you are invested in a single stock ABC Ltd. What
happens if ABC Ltd. performs badly. You will not be compensated for the risk you
have taken with the stock. Now consider the other scenario when you are invested in
a portfolio of 10 stocks - ABC Ltd. and 9 other unrelated stocks. What happens again
if ABC Ltd. performs badly? Your total returns are not hurt as badly, right. You have
mitigated the business risk substantially by diversifying your investment among 10
different stocks!

The return of ABC Ltd. remains the same, please note. Also note that, each stock's
return is affected by different factors (say the stocks belonged to different sectors
-telecom, Banking, Steel,etc.) and they face different risks. So its important to invest
across different categories or stocks - to diversify and reduce risks substantially.

We have seen before that different asset categories - stocks, fixed-income and
money market investments -face varying degree of risks w.r.t. liquidity, inflation and
market risks. So it makes sense that you should diversify across these major
investment categories. Diversification within an asset category such as stocks
(across sectors and large-cap, mid-cap, blue-chip stocks) and even fixed-income
products (long term bonds, money market funds) will further reduce market and
inflation risks. And we have already seen business risk can be mitigated by
diversifying across a portfolio of unrelated stocks.

Now don't go overboard and over-diversify (say across 100 stocks). You run the
over-diversification risk then! There are bound to be pockets of similarity, the
incremental risk mitigation will be minimal. And you lose the benefits of stock
concentration (as opposed to diversification) - but that's another discussion and let's
leave it for another article.

As a senior investor once put to me: Invert the logic. If you do not diversify, you are
putting all your eggs in one basket, and are taking on too much of a risk; it's likely
you will not get compensated for it, by your returns.

Time Diversification

There is another important how to invest mechanism through which we can mitigate
risks substantially - remain invested for a longer time and across different market
cycles. Let's say you invested in 2006 and 2007 in the Indian stock market. If you
had to withdraw money anytime in 2008, you would have incurred substantial losses.
However if you remained invested through 2008 till now you would have pared your
losses significantly and even made gains in some. This works even better across
longer time-periods of 5 years to 10 years.
This is diversification over time and it ensures that you avoid the worst periods of
economic cycles. Time diversification is especially useful for highly volatile
investment categories such as stocks, where prices can fluctuate over the short
term. Staying invested over longer term smoothes these fluctuations.

Which brings us to another important how to invest takeway. If you cannot remain
invested in (volatile) stock investments for relatively long time periods, you should
avoid such investments. Obviously time diversification is less important for relatively
stable investments such as bonds, Money market investments and fixed deposits.

Another senior investor time diversification tip: It is always better to invest or

withdraw large sums of money gradually over time, instead of bulk investment or
withdrawl. Use time diversification to average out costs/gains and reduce risks.

How to invest: is the foundation strong?

Let's try and ensure that you truly absorb the how to invest principles of return and
risk. Your investing success depends on how strong this foundation is.

1. Returns are not known in advance. So, you must make your investment decision
using return expectations that are reasonable and mesh with reality

2. Your actual return may not meet your expectations. Be aware of that possibility
while making all investments

3. Risk comes from the uncertainty surrounding the actual outcome of your
investment; greater the uncertainty, greater the risk

4. Business or industry risk, inflation risk, liquidity risk, and market risk - these are
the major sources of risk. All investments face each of these risks, but to varying
degrees

5. There is a trade-off between risk and potential return: higher the potential
returns, greater the risk; lower the potential returns, lower the risks. Be wary of
claims of high returns, there may be hidden risks

6. These risks can be reduced significantly through diversification. Always diversify

across asset categories (stocks, bonds,money market instruments), within asset
categories, and across individual securities

7. Diversification is also important across market environments — the longer your

holding period, the better. Do not invest in volatile investments like stocks if you
cannot remain invested for atleast three to five years