Measuring Returns In Association With Risk
Risk means, the chance that an investment’s actual return will be different than expected. Risk includes the possibility of losing some or all of the original investment.
Many investors first tell their advisor, to suggest an investment with lowest risk and highest return!
This cannot be far from the truth! How can one expect to reach a farther destination with the same amount of petrol that was filled for a destination that is closer?
The higher the return, the higher the probability of risk that is inherent in an investment.
Risk is measured by calculating the standard deviation of average returns in an instrument.
The higher the standard deviation, the higher is the risk associated with an investment.
When one measures the performance of say a How to Invest in Mutual Funds scheme return over last 1 year, 2 years and 3 years, it should be measured in relation to the risk or standard deviation taken by a fund manager, to deliver those returns to the investor.
Therefore, measuring returns in isolation to risk, is like eating only the sugar from a candy and not tasting the flavor of the candy.
Once the risks are measured in comparison with returns for a particular investment, then the customer will get a holistic picture on his investment.
He can then compare the variation of returns over different periods and see how volatile a stock or a portfolio is.
Again, if the market falls, to what extent does his stock or portfolio fall in relation to the market and in relation to other funds needs to be understood.
It is also good to set a benchmark or standard to every stock, scheme or portfolio, to see how much the scheme’s return has deviated from the benchmark return and whether the scheme has fared above the average benchmark return, after considering the risk or volatility the scheme has taken to deliver the return. That is the true test of a fund manager and is often measured by a term called the Sharpe ratio.
To suggest an investment to a client will comprise of first understanding the risk profile of the client- Risk taking capacity, risk tolerance.
Risk profiling enables the advisor to find out the optimum level of risk based on
Risk required- this is the risk associated with the return to achieve the Financial Goals
Risk capacity will show the amount of risk the client is willing to take
Risk tolerance is the best measure, since it shows the level of risk the client is actually comfortable taking.
Next, the advisor should understand the time horizon for an investment. This is normally linked to the goal of the client.
A longer duration goal, like Retirement Panning, has a longer time horizon to stay invested, before the funds are needed, and therefore, the investment that can be recommended is equities, since any interim fluctuation in the market, will get evened out.
It is scientifically proven that any investment held for more than 12 years, irrespective of market cycles and downturns will provide positive returns of 10% + to the client. So, the longer, one is willing to stay invested, the better is his/ her chance of meeting the target corpus required, and not be too bothered about market vagaries.
A stocks risk can be divided into systematic risk and unsystematic risk.
Systematic or non diversifiable risk- This refers to the risk that is beyond one’s control and is based on market dynamics. More examples are economic and political vagaries, interest rate risk, and macro variables in the government.
Unsystematic and Diversifiable risk- This refers to the risk that is encountered due to known factors like business riks, financial risks where the company has control over factors affecting the risk.
The goal of any investment advisor is to help the client achieve high average returns in equity, while avoiding as much risk as possible.
The ways in this can be achieved is:
Asset Allocation- When a portfolio is apportioned across various asset classes, like equity, fixed income and cash according to an individual’s goal, risk tolerance and time horizon, the investor will be protected from varation in any one particular asset class.
Diversification – by spreading the risk of securities in a wider basket so as to minimize the impact of loss of any one security.
By investing in negative correlated securities. This means, by investing in various asset classes that are negatively correlated so that the fall in one asset class does not hamper returns of the overall portfolio, since the other asset class will provide for returns in volatile markets. Eg, like global diversification helps reduce overall risk in a portfolio when there is domestic turmoil in indian markets, since the global market positive impact averages the returns on the portfolio or investing in gold, shares, and property in India. Each of these asset classes have very little co-relation to each other and this would reduce the overall exposure to risk of a particular asset class
Systematic Investment Planning – By investing a small portfolio of the total portfolio at a regular frequency, the average cost of purchase across is always lower than the current market selling price
Not falling prey to herd mentality and sticking to one’s goals.
By identity’s the correct risk and return that an investor is comfortable to take or in other words the risk capacity of an investor.
In conclusion, it is important for an investor to seek the help of a qualified professional to understand the impact of investing in the numerous investment opportunities in comparison to the risk profile and to understand the meaning of volatility, time horizon and goal reliasation in the overall picture of the investment cycle.
Director and Certified Financial Planner
Dilzer Consultants Pvt Ltd- SEBI Registered Investment Advisor.