The risk of Equity Investments

The risk of Equity Investments

My previous post was about the risks involving debt investments  ,in which we discussed issues around credit and interest rate risks . Now its time to extend this to equity investments. 

What is equity 

Equity , in terms of investments is buying ownership in a business. The investor becomes a full participant in the gains or losses the business makes , unlike debt where the investor is looking for a "certain" cash flow. 

Equity returns

Equity returns are mainly from two sources 

• Price return - If you are able to buy a stock for 100 INR and sell it for 120 INR , you make a 20 INR price return. So follows the commonly used term, buy low, sell higher.  What is important to understand is that you do not realise (i.e. encash) your profits here unless you sell off the share in the trading market. Until then the profit/ loss is a paper profit/loss. 
• Dividends - Sometimes companies return a part of their profit to their shareholders in form of a periodic payments called dividends. This is not a certain payment , though some companies maintain a stable dividend payment ratio. Also to remember here is that some high growth companies who think that their capital is better utilized in new opportunities , do prefer to do so and not pay any dividend. So it can also be said that sometimes dividend paying companies may not be a high growth company. Typically income investors invest in dividend paying stocks. 

Equity investment returns are therefore inherently uncertain , and this uncertainty is a feature rather than a bug. This writeup is all about getting a high level understanding of the uncertainties or risks facing equity investments. 

What is Risk

As mentioned earlier, risk is not a negative term. In financial markets , excess returns can only be generated by taking on risk. Risks can sometimes be avoided or mitigated (at a cost), otherwise one can also choose to take on some kinds of risk

An investor needs to understand the type and quantum of risk that are inherent in her portfolio and ensure that she is comfortable with it. Prudent risk taking is a great way to build wealth over long term

Understanding the types of risk

What i will try to introduce here is a simple framework. (Noble prizes had been won on this area and there is a vast amount of academic work done on this , but my aim is to make it simple for the regular investor and so i will not cover complex topics like the 5 factor model )

When you invest in Equity of a specific company , you are generally exposed to two different kinds of risk 

• Risks Specific to the company - E.g. say for a pharma stock, a clinical trial fail/succeed , or for a logistic firm if a warehouse catches fire or a CEO quits suddenly etc. In finance , we call this idiosyncratic risk
• Broader market related - Issues that affect the overall market , e.g. Ukraine crisis (as i write this), the COVID 19 crisis etc., inflation fears etc. These issues affects your stock , even if its doing well on its own.  We call this systematic risk

The Portfolio Context 

Investment risk is always measured in a portfolio context and the risk borne by a standalone asset is not the correct metric for risk management.  In a portfolio context , risk is not additive and this is perhaps the most important point in here. 

e.g. say you hold a portfolio of nifty50 ETF and gold equally - is the overall risk of this portfolio sum of the risks in the ETF and gold ? No its lesser. Why ? because often when markets crash in fear of something bad , people turn to gold and its value increases. So in a portfolio context the two assets reduce the risk of each other vs their standalone risk

This brings me to the point of diversification 

Diversification - a free lunch ? 

The earlier example of a gold and Nifty portfolio is a simple example of diversification. We have often heard the saying that do not put all your eggs in the same basket , and this is nothing different.

Remember the idiosyncratic risk , mentioned earlier - this can be largely avoided just by diversification 

Is it a free lunch , it can be argued either ways . When you diversify , you may loose the chance of exposing yourself more to a "multibagger" , which you can say is the cost of diversification. But i will argue that its a risk management technique. 

If your style of investing is to identify multibaggers and run a very concentrated portfolio , then there is nothing wrong , given you fully understand that you are taking on lots of idiosyncratic risk , which can go either way (in addition to the systematic risk, which is also in there)

Another style could be running a diversified portfolio of a basket of securities , where you expose yourself only to the systematic risk , and expect a return accordingly. You may gain less from multibaggers , but this also reduces the chances of a dramatic drawdown. 

If you are an investor and not a gambler, chances are that you will prioritize proper risk management over wild returns that can go either way.

Naive diversification

Say you have a 3 stock portfolio, see the 2 portfolios below

1. 33% HDFC bank , 33% Kotak bank , 33% ICICI bank
2. 33%  TCS , 33% HDFC Bank , 33% ITC 

Which of the 2 portfolios do you think is better diversified ? Chances are its the second one. 

Although both have 3 stocks each the first portfolio holds 3 stocks of similar companies (i.e. large private banks) , vs the second one is a bit better split into IT , Banks and Consumer staples. 

The point that i am trying to make is simply buying different stocks is not really diversifying well. There are a lot of interesting ways to do this including complex quantitative modelling of correlation of risk factors etc.. but there are simple solutions available. Simple broad market index ETFs (e.g. a Nifty or Sensex ETF , or a S&P 100 ETF) do a reasonable job of achieving prudent diversification of portfolio. 

Also remember - this diversification also applies to several other ways as well e.g. 

• By geography ( the US market is more than 50% share of global stock markets , India is circa 2% )
• By market capitalization i.e. large cap vs mid cap vs small cap
• Industry , as explained in the example above , sectors react differently to commodity prices and policy changes . 
• Growth vs Value stocks or momentum vs mean reverting stocks (this is for a different day) 

But all of these can be simply achieved by passive means of asset allocation and does not really require one to be a quantitative modelling expert like Jim Simons , or a stock picker like Warren Buffett.

Ultimately for any long term investor an allocation to equity is by far one of the best ways to beat inflation . Generally the problem is with wrong expectations, its the aim to get rich quick by running concentrated portfolios that has a higher chance of ruin , this is where one can avoid dramatic consequences by proper risk management 

The Risks of Debt Investments

The Risks of Debt Investments 

This is my first blog , so my aim is to keep it simple. There are tons of research and professional advice that is available on fixed income ( debt) investments , propagated by brightest of minds in the industry , but my aim is to clear out some basic factors for a common investors buy and hold debt portfolio. 

The material below is focused on an Indian investor..

What are Debt investments

The simplest way to think of this is when you lend money for interest (and principal) and not for a share of the business or venture

Bank Fixed Deposits, Government bonds, Post office bonds , RBI Bonds, Corp Bonds and infact even EPF and PPF savings can be thought of as debt instruments by nature (if not by form)

Why include Debt investments in portfolio - the common opinion

Common wisdom says  debt is low risk compared to ,say stocks or commodities or crypto

While partly correct , this is quite nuanced. Reality is complex and a notion as such like this has the potential to completely disrupt portfolios and long term goals.

In the recent past we have seen several instances of retail investors plight caused by corporate or bank defaults. A lot of these will repeat if we continue to chase higher yield without a proper understanding of the risks facing them. 

Almost all debt investments are subject to various risks and its important for an investor to understand them well. 

Risk Factors Faced by Debt instruments

Credit Risk : 

This is the obvious one. How likely do you think is someone to not return the money you had lend to them. The more that likely hood the more the Credit risk. For e.g. lets say you lend money to a business that is very stable vs one that is new and risky-  surely the credit risk is higher for the latter.

So why would you then lend to a riskier party ? Simply because you will need to be enticed with a higher reward, in form of a higher interest rate. So what i am saying here is , if some debt instrument is offering a higher interest vs another one ( all else equal) then it must be due to poor credit. 

The same logic applies to bank FDs.So if bank X offers a much higher rate than bank Y for a 5 year FD , it will mainly because X is more probable to default (i.e. not return your money). 

So naturally debt issued by central government carry the least credit risk (in India) , and as a result the lowest interest rate vs a corporate bond or a bank FD. 

The EPF , PPF also are government debts , so they carry almost no credit risk , .i.e. there is almost no chance that your PF savings will not be paid to you. But they do carry a higher interest rate ( this is for another time) , so its prudent to invest in them to the maximum extent possible. 

For corporate bonds , a credit score is used as a measure of Credit Risk . The more the AAAs the better the credit (and the lower the interest). CRISIL is a well known provider of corporate credit rating in India. As an e.g. Infosys is rated as AAA Stable vs Shriram Transport Finance as AA+ (CRISIL Long Term rating), which says INFY has a better credit rating (and lower risk), and that the debt issued by INFY may offer a lower interest rate. 

Just focusing on the interest/ yield and completely ignoring the credit worthiness will expose one to undesired credit risk , which is avoidable

Several factors like amount on borrowing  relative to equity, past repayment records , financial strength and performance contribute to determining the credit scoring for Corporates. 

Corporates sometime improve the creditworthiness of borrowing by collateralizing or other credit enhancement techniques to reduce their cost of borrowing

The bottom-line is that there is no free lunch, and an investor is better off staying away from the high yields offered by  a higher credit risk entity , unless one is fully aware of the risk . 

Interest Rate Risk : 

This is often most misunderstood by many , and i will try to explain how it works. 

As a rule of thumb fixed rate debt don't do well in an inflationary environment , or when Central Banks are expecting to hike rates. 

As i write this in 2022, the world around us are all impacted by COVID 19 pandemic and to stimulate the economy the Central Banks have reduced cost of borrowing ( how this works , is something i will cover in a different write-up) , but the bottom-line is rates are at the low end at the moment.                   

Imagine you buy a 10 year Government Bond  which pays you say 4% interest annually. This means for every 100 INR you lend, the government pays you 4 INR every year , for 10 years and then it returns the entire 100 INR. As we had discussed earlier this investment has no credit risk (backed by government is as good as the cash you use), but it surely carry interest rate risk as you will see. 

Now imagine the following happens (which is quite likely) : RBI increases the borrowing rate to 4.5% next year ( Central banks increase rates to control inflation; again a topic for another day). What that will mean is your investment that yields 4 INR is lesser than the current market yield of 4.5 INR. To put it another way your 100 INR principal is worth  96 INR now. 

1.1 Impact of Changing interest rates on Debt Investment

As illustrated in 1.1, a lowering of interest rate has a favorable impact on the initial investment, and a rate hike has an adverse impact. This is classic bond math, and in Finance we use a term called "Duration" and "Convexity" to measure the sensitivity of a bond to changing rates (not to be confused with tenure)

So as you see , the same principles applies to a bank FD/ Corp Bond , but remember that unlike government bonds, they are also subject to credit risk of the issuing bank/corporate

Floating rate bonds revise the interest applicable based on current prevailing rates - contrary to popular opinion this is less risky as its almost insulated not only from interest rate changes but also from inflation to some extent. Instruments are available (GOI floating bonds etc.) which provide these kind of terms. 

The PF investments also get their rates revised every year and in a sense are floating rate - another reason why one should maximize these buckets for the low risk portion of the portfolio.

So the conclusion, is that when economy is facing a recession or slowdown and interest rates are expected to decline in future , is the perfect time to lock in the higher interest rates through FDs or Fixed coupon bonds. When inflation is a bigger worry than growth and we are staring at a rate hike , then its prudent to not get into fixed rate bonds . If one is unsure of future trajectory of rates , then floating rate bonds are the way to go. 

There are several other kinds of risks facing the debt investor like Spread Risk , Country Risk , Term and Liquidity etc. but i choose to avoid them for now to keep it simple for our average retail investor. 

The bottom-line

• Debt investments do reduce risk (measured by volatility of returns) of an all stock portfolio, and an allocation to it is necessary to provide diversification to a retail portfolio
• Debt investments can also provide regular income - in form of interest payments , which can be desirable for income investors
• Credit and Interest Risk are the key risk factors to watch out for, while investing in debt. Remember that "risk" is not a negative term, in fact excess return can only be generated by taking on "risk" in the portfolio. The key is to be calibrated and prudent about taking on risk. 

A quick summary of the risks inherent in debt assets discussed below

1.2 Risks inherent in Instruments

Bank FDs are insured by government of India for investments up to 5 lacs and that is why i consider them slightly safer than a corporate bond (ceteris paribus) , and the EPF/ PPF have their inherent tax advantages , which is why i consider them superior for a retail investor 

That's it for now. Please leave a comment with your feedback and any topic that you want me write more on. 

Manisangsu ( pronounced Manish-anshu  )