What is risk?
An investor will tell you that risk is losing the money he invested. In other words, risk is the permanent loss of capital.
That is absolutely correct. But that is just one dimension. What investors fail to realise is that there is another type of risk – the risk of inadequate return. And this risk is more prevalent than most would like to believe.
Also called shortfall risk, it means failing to reach your investment goal because the return you make on your investments is too low. So if you want your portfolio to achieve its goals – retirement kitty or saving for a child’s education, you need to move some amount of money into equity, which is perceived to be a risky investment.
Let’s look at two investors saving the exactly same amount but in two different instruments. One investor takes the extremely conservative route and opts for a fixed deposit. The other prefers taking some risk and invests in a diversified equity fund with a large-cap orientation.
The conservative investor has earned much less and that too before tax is taken into account. Long-term capital gains on an equity fund is nil, which means if the investor sells his units a year after purchasing them he pays no long-term capital gains tax.
|
Fixed deposit |
Large-cap fund* |
| Base amount |
Rs 2,000 |
Rs 2,000 |
| Monthly contribution |
Rs 2,000 |
Rs 2,000 |
| Period |
10 years |
10 years |
| Return compounded |
Annually |
Annually |
| Balance amount end of 10 years |
Rs 3,66,884.25 |
Rs 5,34,127.49 |
*The 10-year annualised return of the large-cap category of mutual funds, according to Morningstar’s classification, as on June 30, 2015, was 15.94%.
So the point is that investors need to move into more risky investments to avoid shortfall risk. Which brings us to the next aspect that needs to be considered – Is equity all that risky as it is perceived to be?
It all depends on how you deal with this asset class.
To get a perspective, let’s take the case of the legendary Warren Buffett. He learnt from his mentor Benjamin Graham that investors tend to invert the concept of risk. They see stocks as safe when the bulls are galloping ahead, despite the fact that valuations could be really rich at that point. They very easily buy into the mania. When the (inevitable) crash takes place, they along with the bulls create a stampede when heading for the exit. They enter high, exit low and brand equity as very risky. It is for this reason Buffett advised investors to be fearful when others are greedy and greedy when others are fearful. It neatly encapsulates his own winning strategy.
Seth Klarman also tackled this issue of equity being perceived as risky. He believed that risk is not inherent in an investment but relative to the price paid. So amidst tremendous market pessimism when stock prices drop abysmally, that is the time when investors can spot some great bargains. And for those who buy at such levels and patiently wait to ride out the storm before cashing in, won’t find equity to be risky, provided they have done their homework in picking the right stock.
The prime danger of investing in equity is not that you will lose money. The dire risk is that you will react to your losses by selling during a market downturn and deny yourself the benefit of a recovery.
Whether you believe equity is risky or not, you have to consider it as part of your portfolio when saving for long-term goals. Without a carefully measured amount of risk in a portfolio, you fail to employ all the weapons in your investing arsenal. A ‘safe’ investment portfolio will allow you to sleep at night. But there will be a trade-off. To compensate, you would have to massively increase your savings to reach your savings goals, or accept that you’ll end up with less at the end. Neither of which are viable options. In the long run, a portfolio of all ‘safe’ investments will turn out to be very risky for protection against inflation. But a portfolio with at least some risky investments will put you in a better position to help you achieve your goals.