How to identify and deal with risks?
Risk is not something we understand too well. At least, not in the investing arena. We tend to club everything that is complex, unpredictable and capable of harming us, as risky. We also struggle to come to terms with risk. We deny, wish it away or seek to oversimplify it. We focus on the manifestation of risk, not on managing it. When you drive, do you fret about a horrible accident that can take place? Or do you think about ways to prevent it?
Would you not modify how you drive based on your skills and conditions on the road? Risk needs a similar approach. Not a fatalistic avoidance or a callous denial. Let me discuss three common instances of risk that I encounter frequently.
First, consider the risk of a bank deposit. Investors tell me that Rs 1 lakh of deposit insurance is too small for the risk of bank failure. Advisers tell me that investors do not know about this tiny cover, but prefer bank deposits out of ignorance. What is being missed here is that deposit insurance is the last stop. It is evoked when everything else fails and the bank closes down. What should matter to investors is how risk can be managed in normal times. Investors should know how to choose a bank, how to avoid risky banks, and what to do when the situation gets worse. In the normal course. Before the bank fails.
The risk to the depositor depends on the loan book of the bank. An organisation with a good credit process and a low level of non-performing assets is very likely to fully honour its commitments. The risk to the depositor is that even the best processes may not prevent a default. To insure the depositor against this risk, banks do not fund their lending only with deposits, but also have equity capital. Equity bears the risk of the loan book so that deposits do not default. This is why capital adequacy is a big thing for banks.
Since bank failures have a huge impact on the financial system, they are closely regulated to reduce and provide for bad loans and have adequate capital. The investors in bank deposits should look at these two numbers to understand how risky their bank is. Insurance cover is the same across banks and has nothing to do with the risk related to the bank's books. It does not help in understanding the risks of bank deposits.
Second, consider a corporate bond and credit risk. I am frequently asked about the extent to which investors can trust an issuer and the credit rating. Some advisers tend to discount rating agencies, setting a stringent, but unrealistic, performance standard that the rating once issued cannot change. Investors focus on default and whether the issuer may fail to pay.
Credit risk is not about default as a final event but the changing probability of default. A bond might show a high ability to repay at the time of issuance, but subsequent macro and business conditions may erode this ability. Investors should, therefore, worry about this change. They may be receiving an interest rate of an AA bond, but when the bond slips to A, the interest is inadequate due to the increased risk they are bearing. This is the credit risk in a corporate bond.
Rating agencies track and watch the rating and upgrade or downgrade on the basis of new information. They publish the transition in rating over time, which is also used to evaluate their own performance. Managing credit risk requires tracking the credit rating and acting on it, rather than assuming that there is no risk until default or demanding that credit ratings once issued should never change.
Third, consider a mutual fund. The statement, 'mutual funds are subject to market risks', remains poorly understood. Investors continue to seek a minimum return, or ask that fund managers deliver a positive return at all times. They like that the funds be moved to cash, the portfolio be modified, or a trick be performed to keep the returns positive.
A mutual fund is nothing but a managed portfolio. It is not a bank with capital adequacy, nor is it a bond with a credit rating. It is a portfolio of securities. Unlike a bank that provides loans, a mutual fund buys bonds, shares and other securities that are traded on the securities markets. When it builds a portfolio, it reduces the risk of a single security or borrower. However, the overall macro risks continue to remain. This is the market risk in a fund, one that will not go away.
An investor who seeks a mutual fund is looking for market returns and bears market risks. Instead of a savings bank rate, he seeks a return from investing in the money market; instead of a term deposit or bond interest, he seeks returns from a bond portfolio. Instead of a return from an IPO or a share, he seeks returns from a portfolio of equity shares. The benefit of investing in a mutual fund is that the portfolio is less risky by design than a single security, but it is not zero risk. The market risk remains.
The ongoing management of risk, which we referred to, is something that a fund manager does routinely. The risks of the securities held in a fund keep changing and it will reflect in their market prices and, in turn, in the net asset value (NAV) of the fund. Market prices won't wait for risks to manifest, but change on the basis of expectations. An investor in a mutual fund bears this risk.
Therefore, to deal with risk, we need to understand its sources. We can then ask how it is measured. We can find out who manages it and how, and then we can evaluate whether the level of risk suits our temperament and needs.
Several years ago, in his classic book, Against the Gods, Peter Bernstein pointed out that learning to manage risk, perhaps, represents the transition from traditional to the modern. The swelling river that destroyed, the sun whose setting down brought the risks of the dark, and the snake that bit one to death were all revered in ancient times as Gods.
Then man learned to estimate probabilities, and to measure and manage risk. Risk never really goes away, but manifests in forms not always completely anticipated. We have to keep working on it and learn to deal with risk. Living in denial of risk or being fatalistic is unlikely to help in building wealth.Source: Economic Times
Best Regards
Prakash Nair
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