October 2012

Returns from various asset classes for the period 1979-2012

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Returns from various asset classes for the period 1979-2012
Investment
Returns in %(average annual)
Rs 10,000 invested in 1979 becomes in 2012
 
Bank deposit
8
1,36,902
Gold
8.7
1,75,000
PPF
9
 1,87,285
Stocks (BSE sensex stocks)
16.5
18,50,000+ Tax free Dividends (@ Sensex Level 18500)
Over Long terms, Equities have outperformed, the other asset classes by a handsome margin. However, having said that it requires tremendous patience, discipline, good advise, serendipity  and avoiding some costly mistakes in between to achieve those returns. 
 
The ERLI Principle sums it up very well ~ Invest :
 
– Early
– Regularly
– Long term perspective
– Intelligently
 
More on Investing Process and Costly Mistakes to avoid.

Measures of Risk ~ Equity & Debt

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Measures of Risk, Performance, Mutual Funds , Stocks, Standard Deviation, Variance, Beta, Modified duration, Credit Risk, Interest Rate Risk, Weighted Average Maturity  ,Yield Spread,

Investors generally focus on the returns of any asset. They largely ignore the risk factors and most importantly are ignorant of the measures of risk. 

And so, the real Risk comes from not knowing what they are doing ~ Warren Buffett

This post talks about the measures of risks in equities & debt. The awareness of the measures of risk is extremely helpful in designing a comprehensive financial plan, investing, asset allocation etc.

Fluctuation in returns is used as a measure of risk.

Therefore, to measure risk, generally the periodic returns (daily / weekly / fortnightly / monthly) are first worked out, and then their fluctuation is measured.

The fluctuation in returns can be assessed in relation to itself, or in relation to some other index. Accordingly, the following risk measures are commonly used.

Variance

Suppose there were two stocks, with monthly returns as follows: Stock 1: 5%, 4%, 5%, 6%. Average=5%  & Stock 2: 5%, -10%, +20%, 5% Average=5%

Although both stocks have the same average returns, the periodic (monthly) returns fluctuate a lot more for Stock 2. Variance measures the fluctuation in periodic returns of a asset, as compared to its own average return. This can be easily calculated in MS Excel using the following function:

=var(range of cells where the periodic returns are calculated)

Variance as a measure of risk is relevant for both debt and equity.

Standard Deviation

Like Variance, Standard Deviation too measures the fluctuation in periodic returns of a scheme in relation to its own average return. Mathematically, standard deviation is equal to the square root of variance.

This can be easily calculated in MS Excel using the following function: =stdev(range of cells where the periodic returns are calculated)

Standard deviation as a measure of risk is relevant for both debt and equity schemes.

Beta

Beta is based on the Capital Assets Pricing Model, which states that there are two kinds of risk in investing in equities – systematic risk and non-systematic risk.

Systematic risk is integral to investing in the market; it cannot be avoided. For example, risks arising out of inflation, interest rates, political risks etc.

Non-systematic risk is unique to a company; the non-systematic risk in an equity portfolio can be minimized by diversification across companies. For example, risk arising out of change in management, product obsolescence etc.

Since non-systematic risk can be diversified away, investors need to be compensated only for systematic risk. This is measured by its Beta.

Beta measures the fluctuation in periodic returns in a scheme, as compared to fluctuation in periodic returns of a diversified stock index over the same period.

The diversified stock index, by definition, has a Beta of 1. Companies or schemes, whose beta is more than 1, are seen as more risky than the market. Beta less than 1 is indicative of a company or scheme that is less risky than the market.

Beta as a measure of risk is relevant only for equity schemes.

Modified Duration

This measures the sensitivity of value of a debt security to changes in interest rates. Higher the modified duration, higher the interest sensitive risk in a debt portfolio.

The returns in a debt portfolio are largely driven by interest rates and yield spreads.

Interest Rates

Suppose an investor has invested in a debt security that yields a return of 8%. Subsequently, yields in the market for similar securities rise to 9%. It stands to reason that the security, which was bought at 8% yield, is no longer such an attractive investment.

It will therefore lose value. Conversely, if the yields in the market go down, the debt security will gain value. Thus, there is an inverse relationship between yields and value of such debt securities which offer a fixed rate of interest.

A security of longer maturity would fluctuate a lot more, as compared to short tenor securities. Debt analysts work with a related concept called modified duration to assess how much a debt security is likely to fluctuate in response to changes in interest rates.

In a floater, when yields in the market go up, the issuer pays higher interest; lower interest is paid, when yields in the market go down. Since the interest rate itself keeps adjusting in line with the market, these floating rate debt securities tend to hold their value, despite changes in yield in the debt market.

If the portfolio manager expects interest rates to rise, then the portfolio is switched towards a higher proportion of floating rate instruments; or fixed rate instruments of shorter tenor. On the other hand, if the expectation is that interest rates would fall, then the manager increases the exposure to longer term fixed rate debt securities.

The calls that a fund manager takes on likely interest rate scenario are therefore a key determinant of the returns in a debt fund – unlike equity, where the calls on sectors and stocks are important.

Yield Spreads

Suppose an investor has invested in the debt security of a company. Subsequently, its credit rating improves. The market will now be prepared to accept a lower yield spread. Correspondingly, the value of the debt security will increase in the market.

A debt portfolio manager explores opportunities to earn gains by anticipating changes in credit quality, and changes in yield spreads between different market benchmarks in the market place.

Weighted Average Maturity

While modified duration captures interest sensitivity of a security better, it can be reasoned that longer the maturity of a debt security, higher would be its interest rate sensitivity. Extending the logic, weighted average maturity of debt securities in a scheme’s portfolio is indicative of the interest rate sensitivity of a scheme.

Being simpler to comprehend, weighted average maturity is widely used, especially in discussions with lay investors. However, a professional debt fund manager would rely on modified duration as a better measure of interest rate sensitivity. 

More on Mutual Funds

How to deal with value traps ~ Graham Logic

How to deal with value traps , Benjamin Graham Logic, Value Investing, Margin of safety, Investing Principles

Value Investors look out for good/great companies trading at low multiples (be it earnings/book or cash flow). Investors looking for bargain may get attracted to stocks trading at low multiples for a considerable period of time. 

Value trap occurs when the investors lock into the stock at low multiples and the price discovery never happens and the stock price does not budge.

This may happen for any reason such as the whole sector being looked down, or the company / sector in trouble or truly the market not discovering the potential of the stock, inability of the company to withstand competition/technological changes, inability to generate consistent profits etc. There could be many reasons for a value trap happening.

Question is , how should the investor proactively manage the positions in such a situation. 

Benjamin Graham has Stock selection criteria & avoiding value traps

According to Benjamin Graham ~ If the stock does not give you 50% in 3 years, sell it – its most likely a value trap. Nice rule to deal with uncertainty 

As with any investment decision, thorough evaluation and research is required to avoid value traps

Value Investing