How to reduce the risk in your portfolio?

Financial Planning | admin | June 30, 2011 at 7:15 am

In the classic Against the Gods, Peter Bernstein points out that the key difference between ancient and modern times is people's ability to measure and manage risk. Several investors clamour for risk-free products, assurances, guarantees and promises. But just as we do not have perfect spouses, perfect roads, and perfect jobs in the real world, we don't have risk-free investment products as well. We have little choice but to understand and manage risk in our investments.

We all invest our capital in an enterprise or a business activity. The entity with which we entrust our capital uses it to create assets. The primary source of business risk is that despite the assets being managed well, their performance is subject to multiple, unknown factors. The ability of the enterprise to service and return our capital is impacted by these risk factors. The promoters of the business bring in their own capital so that a part of the risk is borne by them. The providers of external capital are serviced through a fixed rate of interest and return of principal in a fixed time frame. Debt is relatively low in risk compared with equity because the presence of equity investors transfers a large chunk of business risk to the latter. This enables servicing debt investors without default. If a bank deposit is seen by investors as safe and risk-free, this comes from the adequacy of the bank's capital to bear any risk arising from the assets it has funded with those deposits.

The only other way to ensure that an investment is risk-free is to back it by sovereign guarantee. The government is not expected to default because it can raise taxes, borrow internationally, or in the worst case, print currency notes. All these actions have implications, but as far as the investor is concerned, he believes the government will keep its promise unless extraordinary circumstances render it beyond its control. However, the Indian government no longer guarantees any investment product other than its own borrowings through the issuance of government securities, for funding the deficit in its annual income and expenditure. The products offered under the National Savings Schemes are the only exception.

To the investor who is seeking safety, government bonds and savings schemes are the first choice. However, the returns from these products may be quite low, exposing the investor to inflation risk. This is because there is no compensation for loss of purchasing power due to inflation. The low inflation-adjusted return makes these products unsuitable for long-term investors. The investors who seek fixed return and relative safety of principal can invest in fixed income instruments issued by other capital seekers. They can invest in deposits, bonds and certificates issued by borrowers such as banks and companies. The risk of default is inherent in these instruments. It can be managed only by choosing and monitoring the quality of assets of these businesses and the adequacy of equity capital to bear those risks. Credit rating agencies offer specialised rating services to gauge these risks. However, investors may still face the risk of illiquidity of such investments. If the underlying risk were to change, investors would want to sell the deposits, bonds or certificates they hold, but there is no market where this can be done readily and at low cost.

The investors who are willing to take on business risks by directly investing in equity of enterprises bear the risk arising from the changing quality of assets. They can take this risk only if they are provided adequate, accurate and complete information about how the assets are performing. They should be able to make their assessment of business risk on a continuous basis and quit the business if they are uncomfortable with the changing levels of risk. This is why equity investors have the right to information disclosures and can sell their equity in a stock market where it is listed. In this case, they are exposed to the market risk. The price of the equity shares they hold moves up and down based on the actions of multiple investors. Their expectation on how the business is likely to perform in the future alters the price continuously.

Every investment is exposed to risk and each of these is of a different nature. If equity bears direct business risk, in case of debt, it is of an indirect nature as a possible default. If non-government debt is exposed to default risk, the government debt is open to inflation risk. The only time-tested strategy to manage investment risks is diversification. Holding assets that are exposed to different risk factors reduces the overall risk of the investment portfolio. Rather than running away from risk, we must learn to understand and use it to our advantage.

Source: Economic Times