Risk, while unwelcome, is an integral part of any investment choice we make. Investment risk is the probability of loss on investment.
Risk, while unwelcome, is an integral part of any investment choice we make. Investment risk is the probability of loss on investment. If this probability is higher, the investment is high-risk; if low, it is low-risk. Investment in equities, commodities, equity mutual funds of various types and market indices fall under the high-risk category, while those in high-grade corporate bonds and bond funds come under the low-risk category.
Risk is also measured by the certainty of returns. If an investment can assure a return with high probability, such investments are low-risk. For example, investing in bond funds may assure returns of 6-10% with high certainty.
Equities do not assure any returns because they vary widely year on year.
There is yet another category of investments known as risk-free investments. Here, returns are certain and do not deviate from the assured value. For example, fixed deposits in banks or post office can be considered risk-free investments.
Types of risk-free investment
Investment in bank fixed deposits (FD) or recurring deposits (RD), Public Provident Fund (PPF), Employees’ Provident Fund (EPF), post office, government bonds (G-Sec), and schemes launched by the government are risk-free. This is because returns are fixed and investors get them at maturity, or as the case may be.
High-grade corporate bonds are considered low-risk. They may be as good as risk-free if they are issued by big companies with a history of business and financial integrity. Every bond has to go through a rating process where agencies such as Crisil, CARE and Icra provide ratings on the bonds. The rating is a measure of company’s ability to pay the interest as well as principal to its investors. A high rating means no or very low probability of default.
It may sound counter-intuitive, but risk-free investments, too, carry some risk. The risk, in this case, is not probability of losing money or of government or institutions defaulting on their payments. Rather, such risks are related to interest rate variations, inflation and macroeconomic failure.
Inflation risk: Inflation adversely affects our investment. High inflation means your real return is low or even negative. For example, in 2013, while the inflation rate was about 10%, the FD rate was 9%. This means that if you deposited R1 lakh in FD in 2013 for a year, you would have received R1.09 lakh in 2014. However, the value of goods R1 lakh used to buy in 2013 would have cost you R1.10 lakh in 2014. Hence, you actually lost 1% in a year by putting money in an FD. Persistent high inflation can be lethal for your investments.
Interest risk: Bond prices are inversely proportional to interest rates. If RBI hikes interest rates, bonds will look less attractive because bank deposits can give you better returns. Demand for bonds will slow down, depressing the prices of bonds. However, your investments benefit if the opposite occurs. This will benefit existing investors. In case of high-grade corporate bonds, another risk is business bankruptcy. These cases are rare, but it is important to know the risk that all the investors face, no matter how low the probability is. Investors should go in for risk-free investments if there is uncertainty in the equity market. Risk-free investments are the answer to market volatility.
At the same time, risk-free investments offer low returns. Hence, if you are in for the longer term, invest partially in the equity markets, which can give much better returns over time. Putting all your eggs in one basket is is not a good strategy.
The writer is CEO, BankBazaar.com