Returns v/s Risk - How to make a prudent choice

“I want to maximize my returns”. I cannot say how many times I have come across this statement when I ask people their objectives. I am sure most of the readers of this article might have this objective at the back or front of their mind. Surely we are all mortal beings and getting a bang for our buck has become second nature whether it’s negotiating with the vegetable vendor or a car salesman.

Now ask the same person about his risk tolerance or specifically “How much short term loss can you tolerate to achieve your objectives” and the answer can be from 0 to 10% depending on whom you are talking to. Also if you ask, “How much time do you think you can wait for a recovery to happen?”, the answer here can vary from 1 week to several years (not believing in the investment but because of the fear of booking a loss).

Just because you have earned fabulous returns in the past following a madcap (sorry midcap) strategy and leverage does not necessarily mean it will fetch the same results. But somehow our mind is trained to believe that this is going to be the case. Even if think conservative we should at least get 25% returns. However mutual funds also like stocks can go down in a sharp correction and some in the recent memory look (May –June 2006) somewhat like this.

It’s not surprising to figure out that most of these funds are small and midcap funds and opportunistic funds. On all quantitative parameters whether it is returns, Beta, Standard deviation, these funds will surely score high and you will do well to understand that just as these funds can go up sharply, they can come down sharply as well. However the above negative returns look like out-performance when compared to the negative returns of around 65-70% post the technology bubble burst.

Chest thumping mutual fund companies which go aggressive for displaying returns during good times do not display or give other qualitative parameters such as the risks that they have taken to achieve these returns. One only looks at the returns generated and decisions are purely made by investors on the basis of this or some rankings which tend to identify stars only after they have gone up substantially and are now likely to go down. Fund houses, which are very aggressive to gather more assets by displaying performance, make their investors go through sleepless nights during corrections.

Fast-forward to a year later and most of the funds were still below the May 12, 2006 NAVs or just near them. 

Because when you fall from a Rs. 100 NAV down to 62 (a 38% loss), you now need a 61% return to get back to your principal, which goes to say that not only High Risk and High Return but High Risk and you need HIGH HIGH (twice as high isn’t) returns to recoup your principal.

Now next time if someone comes up to you with pitches for these exotic and seductive species such as F&O, Aggressive Funds or someone just telling you to invest because of the fancy returns given without due respect to Risk, just skip the bullshit information (referred to as advice by many). Like they say - Bullshit might take you to the Top, but it surely can’t keep you there.

If you do not respect risk, neither will it respect you. If you respect and understand risk, it surely will make your investing lifetime not only a rewarding but a pleasurable one too.

Howz that for a change!!

- Amar Pandit

The author is a practising Certified Financial Planner. He can be reached at amar.pandit@moneycontrol.com

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