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Understanding Investment Risk

Definitions and Concepts
Understanding Risk

e invest in various investment products which generally comprise: 1. Fixed Income Instruments, and 2. Market oriented investments. In the case of Fixed Income Instruments, with a definite coupon rate, there is virtually no risk of not being able to get the desired returns but in the case of other instruments, an investor goes with an expectation of a certain amount of return and the term risk in this context refers to the probability of the investor not getting the desired/expected returns. Risk Avoidance Investment planning is almost impossible without a thorough understanding of risk. There is a risk/return trade-off. That is, the greater the risk accepted, the greater must be the potential return as reward for committing ones funds to an uncertain outcome. Generally, as the level of risk rises, the rate of return should also rise, and vice versa. Before we discuss risk in detail, we should first explain that risk can be perceived, defined and handled in a multitude of ways. One way to handle risk is to avoid it. As explained earlier risk avoidance occurs when one chooses to completely avoid the activity the risk is associated with. An example would be the risk of being injured while driving an automobile. By choosing not to drive, a person could avoid that risk altogether. Obviously, life presents some risks that cannot be avoided. One may view a risk in eating food that might be toxic. Complete avoidance, by refusing to eat at all, would create the inevitable outcome of death, so in this case, avoidance is not a viable choice. In the investment world, avoidance of some risk is deemed to be possible through the act of investing in risk-free investments. Short-term maturity government bonds are usually equated with a risk-free rate of return. In the Indian market place, risk free returns are the returns available on Treasury Bills of a certain tenor; necessarily less than one year and about 90 days or 180 days. Stock market risk, for example, can be completely avoided by choosing not to invest in equities and equity related instruments. Risk Transfer Again as explained earlier, another way to handle risk is to transfer the risk. An easy to understand example of risk transfer is the concept of insurance. If one has the risk of becoming severely ill (and unfortunately we all do), then health insurance is advisable. An insurance company will allow you to transfer the risk of large medical bills to them in exchange for a fee called an insurance premium. The company knows that statistically, if they collect enough premiums and have a large enough pool of insured persons, they can pay the costs of the minority who will require extensive medical treatment and have enough left over to record a profit. Risk transfer can also occur in investing. One may purchase a put option on a stock or on the market index which allows that person to put to or sell to someone this stock or the index at a set price, regardless of how much lower the stock or the index may drop. There are many examples of risk transfer in the area of investing.

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The Risk Averse Investor Do investors dislike risk? In economics in general, and investments in particular, the standard assumption is that investors are rational. Rational investors prefer certainty to uncertainty. It is easy to say that investors dislike risk, but more precisely, we should say that investors are risk averse. A risk-averse investor is one who will not assume risk simply for its own sake and will not incur any given level of risk unless there is an expectation of adequate compensation for having done so. Note carefully that it is not irrational to assume risk, even very large risk, as long as we expect to be compensated for it. In fact, investors cannot reasonably expect to earn larger returns without assuming larger risks. Investors deal with risk by choosing (implicitly or explicitly) the amount of risk they are willing to incur. Some investors choose to incur high levels of risk with the expectation of high levels of return. Other investors are unwilling to assume much risk, and they should not expect to earn large returns. We have said that investors would like to maximize their returns. Can we also say that investors, in general, will choose to minimize their risks? No! The reason is that there are costs to minimize the risk, specifically a lower expected return. Lower the risk, lower the return. Taken to its logical conclusion, the minimization of risk would result in everyone holding risk-free assets such as savings accounts and Treasury bills. Thus, we need to think in terms of the expected return/risk trade-off that results from the direct relationship between the risk and the expected return of an investment. Influence of Time on Risk Investors need to think about the time period involved in their investment plans. The objectives being pursued may require a policy statement that speaks to specific planning horizons. In the case of an individual investor, this could be a year or two in anticipation of a down payment on a home purchase or a lifetime, if planning for retirement. Generally speaking, the longer the time horizon, the more risk can be incorporated into the financial planning. Globally, as well as in India, it is well established on the basis of track record of performance that equities as a class of asset has outperformed other asset classes and delivered superior returns over longer periods of time. With these statistics available, why wouldnt everyone at all times invest 100 percent in stocks? The answer is, of course, that while over the long term stocks have outperformed, there have been many short term periods in which they have underperformed, and in fact, have had negative returns. Exactly when short term periods of underperformance occur is unknown and thus, there is more risk in owning stocks if one has a short term horizon than if there exists a long term horizon. A financial planner has to take into account the time horizon while structuring investment portfolios and the general rule is younger a person is, the longer can be his time horizon, and hence more exposure to equities this follows the rule that risk and returns go up with time. Time has a different effect when analyzing the risk of owning fixed income securities, such as bonds. There is more risk associated with holding a bond long term than short term because of the uncertainty of future inflation and interest rate levels. If one were to lock in a rate of eight percent for a bond that matured in one year, an upward move in inflation or interest rates would have a less adverse effect on the price of that bond than an eight percent bond that matured in thirty years. That is because the bond could be redeemed in one year and reinvested in a bond with a presumably higher interest rate. The thirty year bond, however, will continue to pay only eight percent for the rest of its thirty year life.

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Types of Investment Risk

Systematic versus Unsystematic Risk Modern investment analysis categorizes the traditional sources of risk causing variability in returns into two general types: those that are pervasive in nature, such as market risk or interest rate risk, and those that are specific to a particular security issue, such as business or financial risk. Therefore, we must consider these two categories of total risk. The following discussion introduces these terms. Total risk can be divided into its two components, a general (market) component and a specific (issuer) component. Then we have systematic risk and nonsystematic risk, which are additive: Total risk = General risk + Specific risk = Market risk + Issuer risk = Systematic risk + Nonsystematic risk Systematic Risk An investor can construct a diversified portfolio and eliminate part of the total risk, the diversifiable or non market part. What is left is the non diversifiable portion or the market risk. Variability in a securitys total returns that is directly associated with overall movements in the general market or economy is called systematic (market) risk. Virtually all securities have some systematic risk, whether bonds or stocks, because systematic risk directly encompasses interest rate, market, and inflation risks. The investor cannot escape this part of the risk because no matter how well he or she diversifies, the risk of the overall market cannot be avoided. If the stock market declines sharply, most stocks will be adversely affected; if it rises strongly, most stocks will appreciate in value. These movements occur regardless of what any single investor does. Clearly, market risk is critical to all investors. Market Risk The variability in a securitys returns resulting from fluctuations in the aggregate market is known as market risk. All securities are exposed to market risk including recessions, wars, structural changes in the economy, tax law changes, even changes in consumer preferences. Market risk is sometimes used synonymously with systematic risk. It is also important to know that this risk can not be removed through diversifying across different securities and hence market risk is a non-diversifiable risk. Example of Systematic / Market Risk Suppose the Government announces a corporate tax cut or rise across the board, it is going to effect all the stocks in the market in the same way. This is the systematic risk of scrip, which exists because of market movements. It is going to effect the prices of the stocks of companies which are operating in that sector and not all the stocks. Systematic risk is risk related to economy / market-wide events like interest rates, recessions and wars. These types of events affect all stocks To reduce the impact of systematic risk, we should invest regularly. By investing regularly we average out the impact of risk. Nonsystematic Risk The variability in a securitys total returns not related to overall market variability is called the nonsystematic (non market) risk. This risk is unique to a particular security and is associated with such factors as

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business and financial risk as well as liquidity risk. Although all securities tend to have some nonsystematic risk, it is generally connected with common stocks. Example of nonsystematic risk could include that when a plant of a company burns down, or if a particular line of product of a company flops and if a particular brand was a huge hit in Indian and foreign shores. For instance, a British teacompany, Tetley, is being bought over by Tata tea, then the company financials, valuations and the balance sheet will be affected. Most importantly, the stock prices of Tata tea will also be affected. This phenomenon comes about due to unsystematic risk.With regard to unsystematic risk, say the Government announces tax sops to companies in a particular sector, like the IT sector, then it affects only companies in those sectors. Tax sops were partly one of the main reasons for IT companies to be continually declaring quarter on quarter growth. Unsystematic risks is related to events that dont affect all companies across board. The risks of unsystematic risk is reduced by the diversification of ones portfolio. Remember the difference: Systematic (Market) Risk is attributable to broad macro factors affecting all securities. Nonsystematic (Non-Market) Risk is attributable to factors unique to a security. There is absolutely no way to mitigate a systematic risk. However, by adopting time averaging (popularly known as Rupee Cost Averaging or Systematic Investment Plan) one can reduce the impact of systematic risk. Impact of risk is averaged out by investing fixed amount at fixed interval. Since more investment units will be bought at lower cost and less investment units at higher cost, over a prolonged period, averaging will start working in investors favour. Please note investment could be in any class of asset. It could be in debt, equity, or property. Another strategy, which is superior to time averaging, is value averaging. However due to its complexity it is usually not only recommended by itself, and outside the purview of this book. Reinvestment Risk In the context of bonds, investors look at the current yield as well as Yield To Maturity (YTM) the return one would get if the security were held till the maturity and redeemed with the issuing institution. It is important to understand that YTM is a promised yield because investors earn the indicated yield only if the bond is held to maturity and the coupons (the periodic interest payments) are reinvested at the calculated YTM (yield to maturity). It is important to reinvest the periodic payments, at the same rate as the YTM, to obtain the YTM yield on the security. In the context of long term bonds during the tenor of which the interest rates may fluctuate in any economy, it is virtually difficult for the investor to invest periodic coupon payments at YTM and due to the risk of not being able to get the desired return (YTM) and this risk is referred to as reinvestment risk. The YTM calculation assumes that the investor reinvests all coupons received from a bond at a rate equal to the computed YTM on that bond, thereby earning interest on interest over the life of the bond at the computed YTM rate. In effect, this calculation assumes that the reinvestment rate is the yield to maturity. If the investor spends the coupons, or reinvests them, at a rate different from the assumed reinvestment rate of 10 percent, the realized yield that will actually be earned at the termination of the investment in the bond will differ from the promised YTM. And, in fact, coupons almost always will be reinvested at rates higher or lower than the computed YTM, resulting in a realized yield that differs from the promised yield. This gives rise to reinvestment rate risk.

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This interest-on-interest concept significantly affects the potential total rupee return. The exact impact is a function of coupon and time to maturity, with reinvestment becoming more important as either coupon or time to maturity, or both, rises. Specifically: Holding everything else constant, the longer the maturity of a bond, the greater the reinvestment risk. Holding everything else constant, the higher the coupon rate, the greater the dependence of the total return from the bond on the reinvestment of the coupon payments. Interest Rate Risk The variability in a securitys return resulting from changes in the level of interest rates is referred to as interest rate risk. Such changes generally affect securities inversely; that is, other things being equal, security prices move inversely to interest rates. The reason for this movement is tied up with the valuation of securities. Interest rate risk affects bonds more directly than common stocks and is a major risk faced by all bondholders. As interest rates change, bond prices change in the opposite direction. As a financial planner, while considering investments in various fixed income securities, it is desirable to explain the concepts of interest rate risk as well as reinvestment risk and build the same while structuring client portfolios. If the current scenario is such that the interest rates may rise in the near future and may keep rising for some time to come, may be more of short term debt instruments would find place in the portfolio. On the other side, and in a scenario where the interest rates have reached historic peaks and may fall in the future, it would make sense to commit funds for long term and hence investors should be advised to get into long term bonds/annuities of insurance companies, etc. to protect from these two risks that we have discussed. Purchasing Power Risk A factor affecting all securities is the purchasing power risk, also known as inflation risk. This is the chance that the purchasing power of invested money may decline. With uncertain inflation, the real (inflation-adjusted) return involves risk even if the nominal return is safe (e.g., a Treasury bond). This risk is related to interest rate risk, since interest rates generally rise as inflation increases because lenders demand additional inflation premiums to compensate for the loss of purchasing power. Liquidity Risk Liquidity, in the context of investment in securities, is related to being able to sell and realize cash with the least possible loss in terms of time and money. Liquidity risk is the risk associated with the particular secondary market in which a security trades. An investment that can be bought or sold quickly and without significant price concession is considered liquid. The more the uncertainty about the time element and the price concession, the greater is the liquidity risk. A Treasury bill has little or no liquidity risk, whereas a small cap stock listed in a regional stock exchange may have substantial liquidity risk. Regulation Risk Some investments can be relatively attractive to other investments because of certain regulations or tax laws that give them an advantage of some kind. Interest earned on Public Provident Fund accounts are totally tax free (exclusion from income u/s 10 of the Indian Income Tax Act). As a result of that special tax exemption on the interest as well as the invested amount qualify for deduction from income u/s 80C, the yield on PPF account is much higher than its current interest rate of 8%. The risk of a regulatory change that could adversely affect the stature of an investment is a real danger. A special committee has advised the Government of India to do away with various sections of the Income Tax Act which allow

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exclusions and deductions. If its recommendations are accepted by the Government, the attractiveness of this investment avenue will drop dramatically. Dividends on shares and equity mutual funds are tax free in the hands of investors. These avenues become attractive because of the tax concessions (which are matters of legislation) and these can change. That is one risk associated with investments which can not be avoided. The best solution lies in periodic review of investment plans. Business Risk The risk of doing business in a particular industry or environment is called business risk. For example, some commodities like fertilizers and oil are highly price sensitive in the Indian context and the Government policies of subsidies substantially affect the profitability of the companies engaged in manufacturing/ marketing these products. International Risk International Risk can include both Exchange Rate risk and Country risk. Exchange Rate Risk: All investors who invest internationally in todays increasingly global investment arena face the prospect of uncertainty in the returns after they convert the foreign gains back to their own currency. Unlike the past when most Indian investors ignored international investing alternatives, investors today must recognize and understand exchange rate risk, which can be defined as the variability in returns on securities caused by currency fluctuations. Exchange rate risk is sometimes called currency risk. For example, a U.S. investor who buys an Indian stock denominated in Indian Rupees must ultimately convert the returns from this stock back to dollars. If the exchange rate has moved against the investor, losses from these exchange rate movements can partially or totally negate the original return earned. A stable rather than a depreciating foreign currency (in this case Indian Rupee) is what the investor would be looking for while deciding to invest in that country. The returns to an international investor are always the market returns, positive or negative; the foreign currency appreciation or depreciation is in the intervening period. Obviously, the investors who invest only in domestic markets do not face this risk, but in todays global environment where investors increasingly consider alternatives from other countries, this factor has become important. Currency risk affects international mutual funds, global mutual funds, closed-end single country funds, American Depository Receipts, foreign stocks, and foreign bonds. Country Risk Country risk, also referred to as political risk, is an important risk for investors today. With more investors investing internationally, both directly and indirectly, the political, and therefore economic, stability and viability of a countrys economy need to be considered. More and more international investors are investing in the Indian market because of the political and economic stability of India in the last few years and the belief of continued stability on these fronts. Transparent economic policies and political stability are key factors for attracting more foreign investments in India.

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Exercise
As we saw in the last chapter, Poonam had started investing money regularly from the age of 30. In her portfolio, she also had some stocks and shares. She had some shares of Infosys, and some of Mangal Fertilizers. Within a year of the purchase, there was major fallout in the share prices since the market had been overheated. She had not been sensitive to these issues since she was too busy with her day-today work and she hardly had the time to monitor the performance of the stock market. All the shares across board had dipped by an average of 5-7%. The market had rapidly declined. In case of Mangal Fertilizers, it was a double whammy. Not only had the overall markets fallen, but also that Mangal Fertilizers was now going through a rough patch. The management had decided to split up because of internal differences in the working pattern. To this effect, there was a negative image created and brokers started trading this stock at less than what had been the 90 day average. Poonam also had some ICICI fixed deposit bonds. They were giving 8% rate of return cumulative. She had invested Rs. 100000 in the fixed deposit, for a tenure of 5 years, with the instruction to redeem the interest, every year. After the first year, the interest rates across all instruments increased by 50 basis points, i.e. 0.5%, and again at the time, when one and half years had passed, the interest rate again increased by 0.5%. There are two issues here. The interest, which was available to her, was being used up for some expenses, which were required, thus the promised YTM, the promised yield will not be available to Poonam. Poonam was not reinvesting the coupon interest back at the same rate as the Fixed Deposit rate. Moreover, the interest rates had moved up by 1% since the time, Poonam had made the investments. Thus as she spends the coupon or reinvests them at a different rate from the assumed reinvestment rate, the realized yield that will actually be earned at termination of the investment in the bond will differ from the promised YTM. The coupons if invested, will be a rate higher or lower than the promised YTM. This has given rise to the reinvestment rate risk for Poonams investments. She could choose to withdraw the complete amount and reinvest it elsewhere, or stay put and stick with it till the end. So we also realize that if she had invested for a shorter duration, the risk that she carried would have been less. If the same Fixed Deposit had been made for a year, then at the end of the year, she could have invested the proceeds elsewhere, when the proceeds matured. This variability in the return resulting from the changes in the interest rates is referred to as the interest rate risk. What kind of risk, did Poonam face with respect to Infosys in the markets? What kind of a risk was it with Mangal Fertilizers? Solution : The risk with respect to infosys is Systematic Risk whereas the other risk was Non systemic Risk. The company in which Poonam works, is into exports of content driven products and consultancy. The business, which started in 1990, has now become a $30 million turnover company. It was started by an entrepreneur, Manoj Dhingra who envisioned that the internet and networks would become a powerful revenue driver for many future businesses. Dhingra had amassed fair amount of wealth and as many well heeled Indians, nowadays do; his romance with overseas homes had begun. The company had diversified their operations in London, New York and Dubai. Dhingra needed to travel atleast once in month to Dubai since the operations had started about a year back, but the New York operations were doing well for the last 8 years. He frequently needed to visit both these places. The new RBI act, which provides that any resident Indian is free to acquire and hold immovable property, outside of India, without prior RBI approval, played on his mind. Upto $100000 could

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be remitted every year, per person. He also noted that in Dubai, Indians topped the list of property buyers second only to the British. He carefully studied the country risk and then opted to purchase a property in USA, rather than Dubai. In his mind, since this is a long-term option, he wanted to ensure that he was in a safe country where the economic and political stability in the country was important. This investment would work out well for him, since this property could be converted to a company guest house, where his employees could be housed, in NY rather than staying in a hotel. Mr. Dhingras company faces another risk, can you guess what kind of investment risk that is? Solution: His company is into exports, so each time, the rupee strengths and weakens, it affects his overall wealth. The last 4 months has seen that the rupee has strengthened by almost 10%. The reasons for this are various and largely economic in nature which is a separate discussion altogether. But since it has weakened, his export income has also dropped by 10%. This is called the exchange rate risk and it is caused by the variations in the currency rate market.

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