The returns myth

At a recent interaction with school teachers as part of financial awareness, I was a bit stumped when one of the teachers voiced about being fine with higher returns by taking higher risks. I could not understand what prompted her to be so vocal about a statement which needs a lot of understanding of investment risk for anyone to follow this approach to their investments. It prompted me to ask her later if she understood what the higher risk could do to her investments in search of the higher returns. She had heard the phrase from her investment advisor, before she committed to investing her money in the instrument he had suggested.

Although, she did not recollect the exact detail of the instrument in which she had eventually invested, she was a bit concerned about the state of her investments, after my conversation with her. As I was meeting an investment advisor friend, I asked him about the practical experience he had with higher risk for higher returns. It surprised me when he told that sometimes, his clients asked him why he did not take a relatively higher rate of return by taking a little more risk with their investments.

I have read the traditional investment text books where as per the Capital Asset Pricing Model; an investor is taught that if someone wants to achieve a higher rate of return one should opt for taking on more risk. It is a completely different bit that actually every investor wants to take low risk, but aspire for higher returns. Extremely satisfied with bank deposit returns, an investor would aspire for twice the returns from stock market returns and expect it to be guaranteed. My advisor friend went on to rant about how risk assessment of investors was so difficult.

His reasoning being: the Indian client’s risk comfort changes by the day and sometimes by the hour. It is an extremely complicated factor to arrive at and needed a lot of experience and time with the client to understand their comfort with risk. I understood his predicament and how difficult it was for him to justify his fees when he explained to his clients that wealth optimisation was his job and not wealth maximisation, which is what they considered his job to be.

Steady returns

There is nothing called stable returns even in debt instruments these days, as volatility is a way of life with investments – equity or debt. The approach to equity investing should be low on risk, but leading to a satisfactory and inflation beating return. The risk-reward equation can be skewed in your favour, if you understand the reality that the risk is taken by you when you commit to investing and the returns are a function of how the instrument in which you have invested fares.

On analysing investments in companies that have fared well over different market cycles, the fact emerges that these companies actually require very little capital – fixed assets or working capital to grow. They have very little or no debt on their books, are highly profitable and are run by high quality management. They are also among the most efficient within their industry, and the management is committed to managing their finances efficiently.

Companies like HDFC Bank, ITC, Larsen & Toubro and the list can go on, but these are companies with the characteristics that I stated above. These companies indulge in very low business and financial risks. They rarely load themselves with debt or put the shareholder’s money at risk. Basically, they do not take huge risks. So, what should you do when you want to invest? Don’t be blinded with the parable of high risk, high returns without understanding what it means. And, invest with some rudimentary knowledge of investing; else the chance of losing money is more likely than making it. 

nk@outlookindia.com