Primer. Balancing risks and rewards

High-risk and high-reward are most often used to encourage investment in equities and other risky investments. Not many investors understand that this can easily mean high-risk and high-loss too. The confusion is because investors do not understand what risk is. If high risk necessarily results in high reward, then where is the risk?

In investment, risk means the risk of losing your investment, which may occur as a result of downward spiralling of the value of the investment. However, in financial jargon, risk is a measure of uncertainty of return on investment. This means, an asset whose returns fluctuate year-on-year is riskier than one that gives a specific return every year.

Investment choices At one end of this spectrum of uncertainty in returns is equity. Returns can be as high as 100 per cent in a year, or you may even lose all your money. Equity investment includes investing in individual firms as well as in equity mutual funds.

The return on equity investments is subject to the underlying companies doing well in business, which again is a function of economic growth, general business sentiments, and regulatory environment.

Property and gold investment can be less risky than equities because they retain some value even if their prices go down.

Moreover, fluctuation in the prices of real assets may not be as steep as equity. Then, there are bonds and bond funds that promise a specific return on investment, and hence, prima facie , appear risk-free.

However, bonds are subject to the issuing institutions’ ability to pay interest. If the underlying institutions go bankrupt, there will be no payment.

Additionally, bond prices face the risk of interest rate and inflation. If interest rates go up, bond prices fall and vice versa.

So, while the risk of interest payment may be limited when you go with companies that have had a good track record, from the capital appreciation perspective, risks remain.

Risk-free choices Finally, you have bank deposits, PPF, EPF, Government securities, post office schemes and other such schemes where the possibility of default is practically zero. These are truly risk-free investments.

The only way to know the correlation between the risk and reward is to look at the historical data. Historically, equities have given highest returns over the long run while fixed income securities (bonds, bank deposits, etc) have given the lowest.

The challenge here is to define the long term in cases where the risk is high; for instance, equity, gold or property.

To take the example of equity, if we take 5-10 years as long term, where do you start measuring it? For instance, in the eight years since 2007, the market has given almost nil returns; whereas, stock market investments have tripled in value since 2009. The way out is to look at your risk appetite and investment horizon. If you cannot take 50 per cent loss on your investment, stay away from the equity market.

If you can take only a little risk but still want to invest in stocks, go for balanced funds, which invest partly in equity and partly in bonds. If you do not want to take risk at all, go for PPF, bank FDs and high-grade bonds.

Do your homework Contrary to popular belief, seasoned stock market investors take less risk as they study the company for years and then wait for the right time before putting in their money.

Finally, the only way to build wealth is to minimise risk, save at least a part of your income and invest wisely. The key is to take out a small part of your income every month without fail, and invest according to your convenience.

The writer is CEO of BankBazaar.com

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