My 2 Cents on Risk

What is risk ? This is one of the most common questions asked by my investors. This four letter word looks very simple but it is not so easy to understand. The “hiss” sound in it makes it poisonous. 

Risk is there in everything we do even in eating food there is risk of food poisoning, flying, driving all of them have risks but because of these probabilities we don’t stop doing these activities as these are considered acceptable risks one has to take.

Risk is definitely individual, inevitable and important for any work to be performed.

Generally people confuse risk for volatility which in my opinion is the greatest folly. Volatility is the inherent nature of many things in life. Ocean’s water is more volatile in nature as compared to that of pond’s or river’s. Does this make the ocean riskier than river and pond, not necessarily. Also it depends on who is going to swim? I learnt swimming to make my life less fearful while dipping in a river or enjoying swimming in the ocean.  On the contrary famous standup comedian Biswa says, “Swimming is a useless exercise, this makes your life more vulnerable (riskier) than if you don’t know how to swim.”

Confusing right? He argues that statistics show people who die in water are professional swimmers because a person who does not swim will never go close to water. Sounds logical.

Similarly volatility is higher in the stock prices as compared to bonds, fixed deposit and property prices. Does this mean fixed deposit, bonds and property are safer? Not really.

Recently Sri Lanka has defaulted on its international loan commitment; its bond investors have suffered billions of dollars worth of losses. I can guarantee that many of these investors had or have very less exposure in the equity market or stocks thinking Sri Lanka bond is a much safer bet.

Nowadays a common joke in investment circles is “Bonds are return free risk.”

“Our readers must have enough intelligence to recognize that even high-quality stocks cannot be a better purchase than bonds under all conditions — i.e., regardless of how high the stock market may be and how low the current dividend return compared with the rates available on bonds. A statement of this kind would be as absurd as was the contrary one — too often heard years ago — that any bond is safer than any stock.”

 Ben Graham, The Intelligent Investor

I ask many businessmen about their business and the risk associated with it. A successful seasoned businessman replied, “There is risk in my business , but it is quite manageable and predictable.” Above explanation clearly entails there should be a criterion to understand, measure and mitigate the risk. If risk blows out of proportion then we definitely run into a major catastrophe.

                                                                            Let’s look at two choices of returns

 

Year 1

Year 2

Year 3

Year 4

Year 5

Fixed Returns

5%

5%

5%

5%

5%

Inflation

3%

2%

6%

5%

8%

Real Returns

2%

3%

-1%

0%

-3%

    

Nominal Returns

27.63%

    

Real Returns

0.89%

Equity Returns

7%

10%

20%

15%

-15.00%

Real Returns

4%

8%

14%

10%

-23.00%

    

Nominal Returns

38.06%

    

Real Returns

8.45%


In the above example one would have stable returns in the first case but would have lost purchasing power in real terms due to risk of inflation since $100 would have grown to only $100.89 where it looks very risky in the second case but $100 still grew to $108.45 much larger returns in real terms.

Lessons

  1. One must not invest in anything if she/he does not know adequately about its investments.
  2. One must not invest if she/he does not know the future prospects of it.
  3. One must not invest if she/he does not have a decision making checklist.
  4. One must not invest if she/he is not sure of her/his time horizon.
  5. One must not invest if she/he does not have any defined goals for his investments.
  6. One must not invest if she/he does not know the possible downside of her/his investments.
  7. One must not invest if a crowd is right about some investments and makes lots of money in it like cryptocurrency.
  8. One must not invest if she/he does not have time to review his investments and investment decisions.
  9. One must not invest if she/he does not know his investment manager well.
  10. One must not invest following herd mentality.
  11. One must not invest if she/he does not know the process of investment.
  12. One must not invest if she/he does not know exit criteria of investments.
  13. One must not invest if she/he can not explain it to a 10 years old.


Above list does not guarantee that your
risk is fully covered. It will only help us to understand, measure and mitigate our risk in investment decisions we make. Risk is everywhere and one can not avoid it. At the end of the day we need to make stress free wealth and not just the investment gains. The above list guarantees that.

Yours Truly
Bhuvan Gupta
“Risk comes from not knowing what you’re doing?” -Warren Buffett

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