1.What is investment risk?
Risk must be defined based on investment objective, not on the possibility of negative returns in future
How do you define investment risk? We ask this question because many individuals are worried that equity investments currently carry high risk, having recorded continual uptrend in recent times. In this article, we show that risk must be defined based on your investment objective, not on the possibility of negative returns experience in the future.
You invest to achieve a goal. This could range from buying a house within the next five years to investing for your retirement 25 years hence. Risk in this context is not about earning negative returns.
Rather, it the possibility that you may fail to buy the house because of adverse returns experience of your investment portfolio during the time horizon for the goal.
Note that adverse returns experience is not the same as negative returns experience. Suppose you save ₹53,000 every month for 10 years. Your objective, say, is to accumulate ₹1 crore to make down payment for a house.
Your investment must generate compounded annual return of 8.5% for you to achieve the goal.
The risk in relation to this goal is the possibility of your investments earning less than 8.5% in any year; for a small shortfall in one year can compound to large amount over the remaining time horizon for the goal.
The risk on your trading portfolio is measured differently. In this case, you are trading to generate gains from short-term fluctuations in the market. So, risk is the possibility of loss on your investments sometime in the future.
Your definition of risk is important for you to achieve your investment objectives. Why?
Suppose you create a stock-bond portfolio to meet your goals. Specifically, your bond investment will be in bank recurring deposits and your stock investments in equity funds. The actual return on your recurring deposit is the same as expected return, as the maturity value of the deposit is known at the time of investment.
This means your investment risk can be attributed to your exposure to equity funds. There are couple of ways that you can moderate this risk.
One, you could continually reduce the proportion of your equity allocation and shift the money to fixed deposits starting four years from the end of the time horizon for the goal.
This change in allocation requires additional capital contribution in those years because expected returns on bonds is significantly lower than the expected return on equity. It is preferable to have equity allocation of not more than 30% of the portfolio at the end of the time horizon for a goal.
Two, suppose you expect to earn 10% on your equity investment every year.
In any year when your investment generates greater than 10%, you could redeem units equal to the excess returns and keep this money in a fixed deposit paying annual interest. This money can be used in years when your equity investment generates less than 10%.
You may be wondering why we did not discuss inflation in our discussion about investment risk. This is because your investments are set up to earn nominal returns, not inflation-adjusted return.
You should factor inflation as part of your goal, not as a risk associated with your investment portfolio. Suppose you want to buy a house 10 years hence. You should observe the current price of a similar property and inflation-adjust this price over 10 years.
If actual inflation is greater than assumed inflation, then the house that you want to buy in the tenth year may cost more than your estimated price.
True, you could fail to achieve your goal if this shortfall is significant. But this failure is not due to adverse returns experience of your investments; it is due to the unexpected increase in inflation.