It is preferable to invest through regulated vehicles so that a risk is out of your way
There is lots of literature on risk in investments. Here, we will simplify the concept and enable you to approach your investments with a proper understanding. To start with, let us classify investments broadly into three categories:
Market-dependent: Here, your returns depend on the ‘market’, i.e. price levels of the instruments in the secondary market moving up. Equity stocks, equity-oriented mutual fund schemes, and equity-oriented portfolio management services are of this nature.
Contractual return: Your returns are fixed or contracted upfront. Some people refer to these as guaranteed, but guarantee is a different concept. Bank deposits, post office schemes, corporate deposits and bonds held till maturity are of this category;
Combination of market and fixed returns: To a certain extent, your returns are fixed or known upfront, but depending on the market movement, your final return may be somewhat higher or lower. Open-ended debt mutual funds and insurance policies with guarantee / loyalty additions are of this type.
Market risk
Where returns have to come from the market, it by definition, depends on other market participants being willing to buy it at a higher price/better valuation. This is not in your control. You have to hold on to the investment for the requisite horizon. In the meantime, prices may fluctuate, and obviously when prices drop, you are not going to like it. This volatility or market risk is a part and parcel of market-oriented investments.
The concept of mark-to-market is relevant here. In equity mutual funds, the daily net asset value (NAV) is calculated at market-based prices. It is not relevant that the entire portfolio of the fund is not sold off or purchased back every day. It is that every day, the valuation of the portfolio is on market-based prices, so that investors entering or exiting do it at market relevant levels. Hence, the value of your holding, which is the number of units in the fund multiplied by the NAV, will fluctuate accordingly. To give a perspective on the volatility we are talking about, in January to March 2020, the equity market, represented by the indices, fell by 40%. Since then, the loss has been more than made up and indices have touched record highs. How much an investment will fluctuate is anybody’s call; you may look at historical data for a perspective.
Credit risk
In contractual return investments, market price movement is not relevant. For deposits like bank or corporate deposits, there is no secondary market, hence no question of any market price discovery. The risk here is, if there is a default in the payment obligations, your return calculations, as was known upfront, goes awry. The risk of potential default depends on the entity from which your money is due. If it is from the government (government bonds) or a government-owned organisation (post office deposits/ nationalised bank), your money is safe. Even otherwise, your money would be safe, but you have to take note. If it is a bank, is it a leading private sector bank or an obscure co-operative bank? If it is a corporate deposit, is it rated AAA, placed with a well-known business house? For corporate bonds or bond mutual fund schemes, there are credit ratings, ranging from AAA downwards, which signify the credit risk.
Where your investment is a combination of contractual and market-dependent returns, both the risks are relevant. Market or volatility risk is relatively lesser than only market-oriented avenues. The defined or known return makes it less volatile if all the returns were to come from the market movement only. Credit risk would be there, as known payments such as a coupon (interest) on bonds, have to come from the issuer of the bond.
Regulation/fraud risk
Market risk or credit quality issues are part and parcel of any investment; the risk may be relatively higher or lower. However, there is a completely different type of risk: if the intentions of the executors of the investment vehicle are not honest. In such a case, in spite of the underlying investment giving returns, you may lose even your principal. On one hand we have solid banks regulated by the Reserve Bank of India and well-structured mutual funds regulated by SEBI. On the other hand, there are ponzi schemes that run on the basis of members bringing in new members and fresh money, which gives them handsome returns. Alarmingly, there is no investment as such of the funds. People get lured by the expectation of high returns i.e., greed overtakes investment logic. In the spectrum of regulated (bank, MF) and unregulated (ponzi schemes), somewhere in between, there would be lightly-regulated investment vehicles like chit funds or plantation schemes. It is advisable that before making any investment, check the regulator for that investment vehicle. There are vehicles regulated by SEBI and there are informal structures where some people mobilise money and invest in financial or physical assets, may be through a legal agreement. While courts of law are always there, in unregulated legal agreement-based vehicles it is between you and the entity. A regulator like SEBI would not step in. In certain vehicles like peer-to-peer funding, there are RBI guidelines but the default/legal action responsibility is on you.
Conclusion
Exact measurement of risk is not possible as it is about the future, which we are trying to gauge based on past data or experience. Having said that, it is preferable to invest through regulated vehicles so that one risk is out of your way. On the common risks like market or default, there are mitigants like adequately long investment horizon or superior credit rating. As long as you have a fair understanding of these two risks, you can venture into your investments. However, it is advisable to consult a financial planner for professional guidance.
Disclaimer: All the views in the Blog is personal of the author not attributing to anyone.
