Very often we are told that if you want to earn more money on your investments, you should be prepared to take risks and returns. Starting today, I will take you through the many concepts in the subject of investment risks. It is a complex subject, where economists do not even agree on a single definition of risk.
Let us start with the basic idea of the risk and return linkages. How are they related?
Risk and return are two sides of the same coin
Risk and return are two sides of the same coin. One cannot talk of risk without talking of return. And one cannot talk of return without talking of risk. For example, we cannot say one will get 15 % return in a mutual fund and 7 % in a bank deposit, without also specifying the type and quantum of risks that both investments face.
To compare returns of the bank deposit with that of the mutual fund investment, without comparing the respective risks in those investments is unscientific and wrong. It is also misleading, bordering on fraud. Yet that is how almost all investment ‘experts’ compare! As they say in the world of finance, like must be compared with like. You cannot compare apples with oranges!
In finance there are no free lunches
In the world of finance it is said there are no free lunches. If you are getting a promise of higher returns in a mutual fund, it is because the risk is higher. No one offers a higher rate of interest because they like you or want to make you rich. They offer a higher rate of interest or return, because the risk of investment in that mutual fund is higher.
A reading of this understanding is that higher the promised return, the higher the risk.
Consider this: A small bank or cooperative bank offers 1 % or 2 % more as interest to its customers, as compared to say State bank of India. Or a private company offers 9 % interest rate when the nationalised banks are offering 7 % interest. In all these cases – the small bank, the cooperative bank, the private company – the investment risk is higher than the State Bank. This is the reason they are offering a higher rate of return. If they did not offer a higher rate of return, they would get depositors.
The depositors are lured by a promise of a higher rate of return.
Higher returns are promised to draw investors
The same thing happens with mutual funds. Suppose the mutual fund organisation promised you a 7 % return (when SBI is also offering 7 %), would you be interested in the mutual fund investment? To entice you, you are promised 15 % or even 20 % by the mutual fund organisation. Now investors sit up and take notice, and some are interested enough to invest.
Does this mean that you will get 15 % or 20 % on all mutual funds year-after-year for the next 15 or 20 years? This is what the investment ‘experts’ want you to believe.
Ask your self what the answer should be to the question: Does this mean that you will get 15 % or 20 % on all mutual funds year-after-year for the next 15 or 20 years? In my subsequent posts expect more inputs on risk and return.