Saturday, April 14, 2012

Know risks before the plunge

This article was originally published in Postnoon on April 13th, 2012


http://postnoon.com/2012/04/13/know-risks-before-the-plunge/43256

On my way to ISB on Monday, I saw a motorcyclist speeding on the Gachibowli road hit a car taking a u-turn. The car was damaged and the motorcyclist suffered good deal of injuries. On enquiry, the rider said that he was in a hurry to meet his sister who was not well.

This got me thinking about the risks people take in their lives. Even though we read about accidents due to speeding very frequently, we still drive fast to save a few minutes. A cricketer tries to hit a six with every ball, taking the risk of getting caught on or near the boundary.

An investor faces similar risks. In order to earn higher returns, investors often take risks which may not be compatible with either their risk appetite or risk taking ability.

Taking a sip of the coffee, Prof. Nicky asks Srikanth, “Have you watched the movie 3 Idiots?”

Srikanth: Of course. Who hasn’t?

Prof. Nicky: Do you remember the scene where ‘Virus’, summoned Raju and Farhan to his office and told them to leave the company of Rancho?

Srikanth, proudly: I remember the entire movie, dialogue by dialogue. I’ve watched it 23 times.

Prof. Nicky: And how many times have you read Yasaswy’s book on investments?

Srikanth, descending down to the earth: Uhhh… Prof. I was about to start reading it the coming weekend… I Uhhh… thought… uhhhh…

Prof. Nicky: Ok. Coming back to 3 Idiots. So what was ‘Virus’ trying to explain to Raju and Farhan by comparing the income of their families with that of Rancho’s?

Srikanth: Ummm… I guess he was trying to tell them that they cannot afford to be thrown out of the course as passing and getting a good job was very important for them. Their families were not as well to do as Rancho’s.

Prof. Nicky: Exactly. This means that they do not have the risk taking ability, even though they have the appetite. Generally youngsters, with lesser responsibilities, single status, have more appetite to take risk.

Srikanth: But an investor wants returns. How are all this connected to returns?

Prof. Nicky: Alas, that what the investors don’t understand and that’s what I am trying to explain to you. There are different asset classes like Bonds, Equities, Commodities, Gold, Derivatives, Art and Artifacts, Real-Estate, etc, available for an investor to invest in. Each one of them has a risk profile of their own.

I can see that I am losing you. Let me explain.

Risk has a negative connotation in our day to day life, but not entirely so in the case of Investments. The uncertainty or deviation from expected returns is known as risk in the case of investments. For example, if you invest in the shares of Reliance Industries Limited, with an expectation to earn 20 per cent return in one year, an actual return of — 30 per cent is a deviation from the expectation, just as a return of 30 per cent.

If you take the case of fixed deposit in a bank, you get as much as you expect. So it is riskless, unless the bank goes bankrupt. But in the case of Reliance, your returns would depend on the performance of the company, the dividends, the future projects etc. So the uncertainty is much more.

Srikanth: I get it. So if I do not have the risk taking ability, I should not put my money in risky assets. But if I do have the risk taking ability as well as the appetite for it, I can invest in risky assets, though I should be aware of the risks that I am taking.

Prof. Nicky: Ah… there you go… Perfect… I couldn’t have put it better!

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