As an investor your objective is simple – 'Maximise return and minimise risk'. The first part of the equation, the return, is relatively easy to understand. It is objective in nature, in as much as, when you undertake an investment, you have a fairly good idea as to what the return is going to be. It is quantifiable, it is a number.

However, what about risk? How do you quantify it? How do you minimise it? How do you achieve the fine balance required between risk and return to optimise your investment consistent with your goals?

Well, let us begin with understanding the concept of risk and its various facets.

Systematic Risk
Systematic Risk, as the name suggests is the risk inherent in the economic system. Macro factors such as domestic as well as international policies, employment rate, the rate and momentum of inflation and general level of consumer confidence etc. are what constitute systematic risk. Generally, investors cannot hedge or diversify against this risk as it affects all kinds of asset classes and affects the entire economy as such.

Unsystematic Risk 

This is the risk inherent in a particular asset class. The best way to combat this risk is by diversification. However, one must remember that the diversification must be in the class of asset and not the asset itself. An example of the above is evenly distributing your portfolio in bank deposits, Reserve Bank of India (RBI) bonds, real estate and equities. That way if a certain unsystematic risk affects let's say the real estate market (say the prices crashes), then the presence of other classes of assets in your portfolio saves you from a total washout. However, note that diversifying within the same asset class (buying different equity shares) is not strictly combating unsystematic risk.

Understanding Unsystematic Risk 

The one thing that almost all investors would agree upon is the fact that equity is definitely more risky than debt. Irrational exuberance with a rising market has left many an investor losing their shirts and in some cases even more sensitive garments.
 

However, does this mean that investing in debt instruments is entirely risk-free? Unfortunately, the answer is in the negative though the volatility is much less. So first, let us examine what kind of risks do debt instruments pose.

Interest Rate Risk 

Interest rates and prices of fixed income instruments share an inverse relationship. In other words, when the overall interest rates in the economy rise, the prices of fixed income earning instruments fall and vice versa. Interest rates in the economy may fluctuate due to several factors such as a change in the RBI's monetary policy, Cash Reserve Ratio (CRR) requirements, forex reserves, the level of the fiscal deficit and the consequent inflation outlook etc. Extraneous factors such as energy price fluctuations, commodity demand and supply and even capital flows may result in rates fluctuating.

Then there are the event-based factors that affect interest rates. For example, the 11/9 episode in the United States of America and 13/12 in India. If there is a war, interest rates will rise. However, typically such events are temporary in nature and in fact a good fund manager can actually take advantage of such hiccups.

To illustrate how fluctuations in interest rates affect the returns, let us take the example of mutual funds (MFs). Adjusting the portfolio to the market rate of returns is called 'marking to market'.

We assume that the current Net Asset Value (NAV) of the MF is Rs. 10 and its corpus is Rs. 1000 crores. This means that if the fund sells all the assets of the scheme and distributes the money on equitable basis to all the unit holders, they will receive Rs. 10 per unit. Now suppose, the interest rate falls from 10% to 9%. Immediately, thereafter you wish to invest Rs. 1 lakh in the scheme. Realise that the entire corpus of the fund stands invested at an average return of 10%. If the fund sells the units to you at it's current NAV of Rs. 10, you will be allotted 10,000 units. This will benefit you immensely. You will be a partner in sharing the benefit of the higher returns of 10%, though the fund will be forced to invest your Rs. 1 lakh at the lower rate of 9%.

This is injustice to the existing investors. Therefore, something has got to be done to protect their interest. Here comes the 'mark to market' concept. The fund raises its NAV to Rs. 11.11. You will be allotted only 9,000 units and not 10,000. The returns on 9,000 units at 10% would be identical with the returns on 10,000 units at 9%. In other words, the NAV rises when the interest falls. 

Credit Risk

This is the risk of default. What if the company whose fixed deposit you invested in goes bankrupt? There have already been several such cases. Deposits with plantation companies and time-share resorts are more cases in point. True, you have legal remedy...but everyone knows how much time our courts take. 

The only factor, which dilutes this risk somewhat is the credit rating. Fixed income earning instruments get rated for varying degrees of safety. Investing in a highly rated instrument is safe but not sufficient. Firstly, the instrument may be down graded, you have to be on the lookout for the same. Then there have been cases where the issuer has got rated by different agencies but chooses to indicate only the higher ones.

Elimination of Risks 

There is some good news though. Credit risk can be simply eliminated by investing in sovereign securities --securities issued by the government. There is simply no risk of default. Or so we hope, for retail investors, MFs offer gilt schemes, where almost the entire corpus is invested in sovereign securities thereby achieving the same result.

Interest rate risk discussed earlier is always prevalent. However, it comes into play only when a transaction is undertaken during the pendancy of the fixed income instrument. Ergo, it follows that if the investment is held till maturity, there would be no interest rate risk.Investments such as Public Provdent Fund (PPF), Relief Bonds etc. are normally held till maturity. These are examples where both the risks inherent in debt instruments are at a bare minimum.

Government Action Risk

This is a unique kind of risk, which has reared its ugly head in recent times. In the previous paragraph, it is mentioned that the interest rate risk is eliminated by simply holding the instrument till maturity.

However, such principles of investment had not contended with unilateral governmental action. For example, the rates of PPF over the past three years have been consistently reduced by the authorities from 12% p.a. to 8% p.a. To add insult to injury these rates are applicable on the entire corpus and not on additional investment. Relief Bonds have come down to 8%. Rates on other small saving instruments have also been slashed across the board. Unfortunately, there is no escape from this risk --- that of our government!

Measuring Risk

So far, we have acquainted ourselves with the kinds of risks inherent in investment instruments. However, merely knowing this much may not be enough to take an informed decision. The article began with the premise that return is objective since it is quantifiable. Then, can we not try and quantify risk?

Well, age old statistical tools like standard deviation and regression help us do precisely that. Next time we shall touch upon these basics of Modern Portfolio Theory, which enable you as an investor to actually quantify the risk existing in the investment you are contemplating. This will be the subject matter of the next article.

By Sandeep Shanbhag

The author is Director of A N Shanbhag NR Group, a Mumbai based tax and investment advisory firm. He may be contacted at sandeep.shanbhag@moneycontrol.com