|Investment||Returns in %(average annual)||Rs 10,000 invested in 1979 becomes in 2012|
|Stocks (BSE sensex stocks)||16.5||18,50,000+ Tax free Dividends (@ Sensex Level 18500)|
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.
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.
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 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.
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.
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.
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.
Just yesterday, I was having a discussion with a friend who was keen on knowing about the markets and where they are heading. He is interested in investing for long term.
Instead of providing an answer ( Well!!! I myself do not know, nor does anyone else know where are the markets headed…. Anyone who claims he does should would just be sitting in Hawaii, enjoying the beaches and punching away his trades to glory isn’t it!!!! 🙂 )
OK so I probed hime further with a few questions about his financial goals, current assets and liability situation, savings etc and made him aware about the kind of questions he should be asking in order to achieve financial (investing) success over a long run.
Of course, he will have to devote some time towards understanding the products available to invest further… But diagnosing the current situation and having a clarity of financial / life goals is the important first step.
Here is a nice article in 4 parts which I had written quite some time back and wanted to bump up.
Life can only be understood backwards; but it must be lived forwards.
In the process of investing, one often makes mistakes. There is nothing wrong in it. However, repeating the same mistakes should be avoided. This is so much easier said then done. Never-the-less, we can always try. So, Here are some of the most common investing mistakes which investors generally make and some of which even I had made in the earlier part of my investment years.
I have been investing since 1997. Earlier part of the investment was when I was in US and then later after moving to India in 2005. I have been investing in both shares and real estate.
Of course, learning from the mistakes, continually, the investing experience has truly been rewarding experience. You can also cultivate good habits of investing by avoiding the following most common mistakes.
So here goes……..
#1. Investing without a Goal
If one does not know to which port he is sailing, no wind is favorable.
Beginning investors often begin by Casual Investing without any goals. This quite often leads to pain and heartburn because, without any goals, investments are treated as speculation instruments solely aimed at making more money in a shorter span of time, by chasing market performance and acting on market swings, something similar to get-rich-quick scheme. (Speculation is a different ball game and of course, many people do succeed at it. However as in Investments, there are different set of rules, full time efforts, and a different mind set and discipline which needs to be followed.).
Different goals require different strategies. Broadly goals can be divided into three types according to time frames.
Long term Goals – typically 7+ years (e.g.: retirement corpus, child education, child marriage etc.) should invest in Long term high risk/high return growth investment assets.
Medium term goal – typically 2 – 7 yrs (e.g.: deposit on house, planning a sabbatical from work etc.) Require balanced risk investment strategy,
Short term goals – typically less than 2 yrs (e.g.: overseas holiday, purchase of car, any major house improvement expense etc) require conservative investment strategy.
So, Some of the following questions have to worked upon and answered to full satisfaction before setting out for investment: What am I investing for (Goal)? How much do I need for the goal to be met? What is the time frame of the investment going to be? Where do I need to invest? Should I do lump sum investment or Periodic investment? And so on…
Remember, failing to plan is planning to fail
#2. Not Starting to invest Early enough
This is one of the most common mistakes made by investors. Most of us keep waiting for the right time, or the right price, or the right time to begin investing. Remember, Time in the market and not timing the market is the simple way to success in investing. Please read my earlier post on Invest early, Invest Wise, Utilize the power of compounding.……….. You can read posts here. (Part I, Part II , Part III & Part IV)