How to Invest |Understand Return and Risk |Risk Return analysis

How to Invest? First, understand basics of return and risk, with the trade-offs associated with each investment asset class. Learn to use diversification as a means of mitigating these risks.

  1. How to invest: the basic principles
    1. First things first
    2. Understanding Return and Risk
    3. The risk return trade-off
    4. Diversification: Mitigating Risks
    5. Time Diversification
    6. How to invest: is the foundation strong?

How to invest: the basic principles

Now that you have figured out why investing is a smart thing to do, let’s move on to – how to invest.

For a beginner investor its tough not to get overwhelmed – market publications and websites are full of 5-star rated Mutual Funds, ULIPs that promise the best of insurance and investment (but actually isn’t), the lure of momentum stocks that everyone at office seems to be making a quick buck on – hell, just how and where does one start?

Relax. This 2 part series, on how to invest, will make life simpler.

First you will need to understand the relationship between risk and return, and the associated trade-offs between the two. Next you will learn established ways of mitigating such risks.

Equally important is to understand how your individual circumstances affect your investment decisions. Your tolerance for risk (can you stomach a 10% temporary loss), your return requirements (are you investing towards buying a house, or you need some regular monthly income), your investment horizon (the time you can remain invested), as also your tax status will impact decisions on what kinds of investments to go for, and what to avoid.

The 2nd part of this series – how to invest: Your individual investment profile, will address that.

So much for an overall picture on the how to invest decision making process. Let’s get started on the details.

First things first

Before we get going on return and risk principles and how to invest, we will first need to talk a little bit on how to structure your financial life to make it possible to invest.

When you start investing you must do so with a clean slate. There’s no point in trying to save while you have high-interest credit card or personal loan debts accumulating by the day. Sure, some kind of debts can be low-interest or useful for tax-saving purposes such as your housing-loan. But you will be well-advised to get ready to close off your high interest debts, before you start thinking on how to invest.

Next get into the habit of forced saving. You pay bills every month – electricity, to mobile to cable bills, right. Just add yourself at the top of the list. Every month as you get your salary credited to you account, set aside a sum to save or invest. Start with a minimum of 20%. The more you save, the more wealth you can create. Even a few rupees saved now will do more than lots of rupees saved later!

Understanding Return and Risk

At the core, understanding how to invest is all about returns and risk. Return is measured by how much one’s money has grown over the investment period. Returns are not known in advance. Instead, you can only make an educated guess as to what kind of return to expect.

Expecting a return of 25% just because your stock-investing friend say’s that’s what you will make may be unreasonable. Most expectations are based on what’s happened in the past. Unfortunately history doesnt always repeat itself! We have all seen the highs of 2007, followed by the lows in 2008, haven’t we?

However we can draw reasonable conclusions about future returns by looking at longer-term data – 5yr and 10yr records – ofcourse with the express understanding that these returns are not guaranteed.

Even if your return expectations are reasonable, there is the possibility that your actual returns turn out different than expected. You run the risk of losing some or all of your original investment.

Why is that? Because of an uncertain future ( e.g. global economic environment), uncertainity over the quality and stability of investment, and some other uncertainities. In general, greater the uncertainity, greater the risk. Some common sources of uncertainity or risks that we must absorb, while we learn how to invest, are:

Business and Industry Risk
There might be a industry-wide slowdown, or even a global economic recession as we are experiencing now. That presents an uncertain future for any business, isn’t it. Or the business might see its earnings dropping significantly say, due to management ineptitude/wrong decisions. The lower earnings (due to any of the above) may cause the companys stock to fall.

Inflation Risk
The money you earn today is always worth more than the same amount of money at a future date. This is because goods and services usually cost more in the future, due to inflation. So its important that your investment return beats the inflation rate. If it merely keeps pace with inflation then your investment return is not worth much. We have seen inflation soaring upto 11% in 2008, now in 2009 its at 1 or 2% levels. Perhaps an average inflation rate over next 10 years may work out at 5-6%. Who knows, there’s enough uncertainity here too.

Market Risk
Market Risk is about the uncertainity faced in the stock market. Several macro and micro economic details singularly or plurally can spook the market. We have seen how the massive mandate in elections 2009 has re-invigorated the market. On the other hand, A fragmented hung parliament may have caused the market to nosedive? Even for a well-managed business growing profitably, its stock may drop in value simply because the overall stock market has fallen.

Liquidity Risk
Sometimes you are not able to get out of your investment conveniently, and at a reasonable price. For example in 2008, you may have found it tough to sell your house at a price you wanted. In 2007 however you could have gone laughing to the bank. The market may simply be inactive or it may be just volatile – and that means you cant sell your investment or get the price you want, if you needed to sell immediately.

Now here comes an important takeway in learning how to invest – understanding the risks associated with different asset classes.

The degree of risk varies widely between asset classes and even among investment options in a asset class. We all appreciate that a government-backed bond like a NSC or PPF scheme is safer than that offered by a reputed corporate. Next consider inflation risk – stocks face far lesser inflation risk than bonds. While bonds have managed to just keep pace with inflation, stocks have historically outpaced inflation, by some 10% annually on an average in India. However short-term bonds and money market investments face very little liquidity risk, while stocks face relatively greater liquidity risk.

The risk return trade-off

The next important takeaway in learning how to invest, is understanding risk/return analysis or trade-offs. Every investor would want the highest possible return for the level of risk (uncertainity) that he is willing to accept. In a competitive marketplace, this results in a trade-off. Low-risk investments naturally are associated with low potential returns and high-risk investments with high potential returns.

If we look at long term returns, stocks in India have historically produced returns that average 15% annually, while bonds have averaged 6-9% annually. This reflects the risk/return trade-off.

Its important to remember that this is on an average for the asset class. Specific investment options may produce far higher or lower returns. For example an investment in ITC for the last 15 years has provided returns in excess of 30% annually. It’s useful to remember that the risk is in the uncertainity. If you can evaluate a stock investment and weigh the potential returns with the uncertainities (or, relative lack of uncertainity) vis-a-vis another stock investment, you stand to gain tremendously from these trade-offs too!

There’s another useful service these risk/return trade-offs serve. They flag off highly risky investments. Any scheme advertising high potential returns usually flags high risk, even though the risks may not be apparent at first glance. For example, quite often we see Corporate Bonds offering far higher yields than usual (usually, from unknown companies), don’t we – now that you know how to invest basics and the risk/return trade-offs, I am sure you will treat these with caution and a healthy dose of skepticism!

Diversification: Mitigating Risks

Diversification is a strategy that can be neatly summed up by the timeless adage “Don’t put all your eggs in one basket.” We have learnt how to invest, is all about returns and risk principles. You will now probably look to invest in a stock only after analysing that you will be compensated well (for the risk you are taking by investing in the stock), from the stock’s returns.

Now consider the scenario that you are invested in a single stock ABC Ltd. What happens if ABC Ltd. performs badly. You will not be compensated for the risk you have taken with the stock. Now consider the other scenario when you are invested in a portfolio of 10 stocks – ABC Ltd. and 9 other unrelated stocks. What happens again if ABC Ltd. performs badly? Your total returns are not hurt as badly, right. You have mitigated the business risk substantially by diversifying your investment among 10 different stocks!

The return of ABC Ltd. remains the same, please note. Also note that, each stock’s return is affected by different factors (say the stocks belonged to different sectors -telecom, Banking, Steel,etc.) and they face different risks. So its important to invest across different categories or stocks – to diversify and reduce risks substantially.

We have seen before that different asset categories – stocks, fixed-income and money market investments -face varying degree of risks w.r.t. liquidity, inflation and market risks. So it makes sense that you should diversify across these major investment categories. Diversification within an asset category such as stocks (across sectors and large-cap, mid-cap, blue-chip stocks) and even fixed-income products (long term bonds, money market funds) will further reduce market and inflation risks. And we have already seen business risk can be mitigated by diversifying across a portfolio of unrelated stocks.

Now don’t go overboard and over-diversify (say across 100 stocks). You run the over-diversification risk then! There are bound to be pockets of similarity, the incremental risk mitigation will be minimal. And you lose the benefits of stock concentration (as opposed to diversification) – but that’s another discussion and let’s leave it for another article.

As a senior investor once put to me: Invert the logic. If you do not diversify, you are putting all your eggs in one basket, and are taking on too much of a risk; it’s likely you will not get compensated for it, by your returns.

Time Diversification

There is another important how to invest mechanism through which we can mitigate risks substantially – remain invested for a longer time and across different market cycles. Let’s say you invested in 2006 and 2007 in the Indian stock market. If you had to withdraw money anytime in 2008, you would have incurred substantial losses. However if you remained invested through 2008 till now you would have pared your losses significantly and even made gains in some. This works even better across longer time-periods of 5 years to 10 years.

This is diversification over time and it ensures that you avoid the worst periods of economic cycles. Time diversification is especially useful for highly volatile investment categories such as stocks, where prices can fluctuate over the short term. Staying invested over longer term smoothes these fluctuations.

Which brings us to another important how to invest takeway. If you cannot remain invested in (volatile) stock investments for relatively long time periods, you should avoid such investments. Obviously time diversification is less important for relatively stable investments such as bonds, Money market investments and fixed deposits.

Another senior investor time diversification tip: It is always better to invest or withdraw large sums of money gradually over time, instead of bulk investment or withdrawl. Use time diversification to average out costs/gains and reduce risks.

How to invest: is the foundation strong?

Let’s try and ensure that you truly absorb the how to invest principles of return and risk. Your investing success depends on how strong this foundation is.

1. Returns are not known in advance. So, you must make your investment decision using return expectations that are reasonable and mesh with reality

2. Your actual return may not meet your expectations. Be aware of that possibility while making all investments

3. Risk comes from the uncertainty surrounding the actual outcome of your investment; greater the uncertainty, greater the risk

4. Business or industry risk, inflation risk, liquidity risk, and market risk – these are the major sources of risk. All investments face each of these risks, but to varying degrees

5. There is a trade-off between risk and potential return: higher the potential returns, greater the risk; lower the potential returns, lower the risks. Be wary of claims of high returns, there may be hidden risks

6. These risks can be reduced significantly through diversification. Always diversify across asset categories (stocks, bonds,money market instruments), within asset categories, and across individual securities

7. Diversification is also important across market environments — the longer your holding period, the better. Do not invest in volatile investments like stocks if you cannot remain invested for atleast three to five years

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