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How the risk and return trade off can be applied in real life

 

How the risk and return trade off can be applied in real life


How the risk and return trade-off can be applied in real life


Pick any book on finance and it will say that risk and return go hand in hand in other words the more risk you are willing to take the more returns you are likely to earn vice versa 

but this premise also leads to some interesting questions for instance why is it that gamblers who take up so much of the risk often end up losing most of their money 

similarly, why is it that companies with large amounts of debt which is obviously a very risky form of capital tend to fail much more than conservative companies 

in both these cases, a large amount of risk was taken but the commensurate returns were low or negative 

so the real question is are risk and return really siblings as our finance books tell us or are they at best merely distant cousins 

that's the question we'll try to answer in this article as we explore the true relationship between these two essential investing variables

Under the modern portfolio theory or MPT as it's commonly called the more volatile a stock the riskier 

Its is the volatility is calculated by comparing the past returns produced by a stock with the historical returns produced by the overall market this gives us a positive or negative trend line which is called beta and it is generally assumed that the trend will continue in the future as well 

Now companies whose beta is greater than 1 are classified as high beta stocks and includes stocks like HDFC Bank, Bajaj Finance and Adani Transmission which has a Beta of 2.1.

So what this number 2.1 actually means is that if the stock market were to move by 10 per cent the stock market of Adani transmission would move by 2.1 times of 10 which means it will go up by 21 conversely 

If the stock market were to fall by 20 percent then Adani transmissions stock price would fall by 42 and it's in this context that most financial experts and advisors tend to tag these high beta stocks as risky stocks 

now just like we have high beta we also have low beta which represents those stocks where this beta number is between zero and one Bharti Airtel, Asian paints, Wipro, Dr.Reddys are just some companies that have a low beta and are expected to act as safeguards against any correction in the stock market 

as one might have figured out by now low beta stocks are tagged as less risky stocks and then we also have negative beta which represents those investments that move in an opposite direction to the stock market 

This inverse movement is generally seen with gold instruments like gold UTF,  bullion and gold mutual funds that often show up on the negative beta list it's a list that almost never features any popular stock 

But I did use the word almost which means there are exceptions and we found one in Ruchi soya industries limited which has a negative beta of 1.42 

Now if you have been tracking the performance of Ruchi Soya over the last two years then this inverse relationship should not come as a surprise 

Take the period between February and June of 2020 for instance during these five months the Nifty was down by 10 per cent but the Ruchi soya stock had gained over 7 000 and again from July of 2020 until April of 2021 when the nifty had risen by 40 per cent the Ruchi soya stock went in the other direction and lost about 50 per cent of its value.

So let's go back to the MPT so effectively what the MPT is telling us is that if one needs to measure the risk of stock then all one needs to do is to focus on the beta in other words.

An investor can ignore things like what the company manufactures the competition it faces the quality of the management its growth prospects etc and simply invest in high beta stocks if he or she wants a high return this sounds a little absurd doesn't it but that's the traditional view of the relationship between risk and return.

In 1984 warren Buffett gave a talk at Columbia University in honour of the 50th anniversary of the publication of benjamin graham and David dodd's book security analysis.

The talk was aptly titled the super investors of graham and Pottsville and it challenged the idea that equity markets are efficient through the study of nine successful investment funds that have generated long-term returns much above the market index 

If you haven't read the corresponding article then it comes highly recommended and the link to that can be found in the description of this video now there's a line in that talk that beautifully explains a value investor's view of risk and return and it goes like this 

If you buy a dollar bill for 60 cents it's riskier than when you buy a dollar bill for 40 cents but the expectation of reward is greater in the latter case the greater the potential for reward in the value portfolio the less risk there is 

To put this simply what Warren Buffett is saying here is lower the risk higher the return now people who have been educated in classical finance might find the statement farcical and therefore I present the following example 

Let's say there are two shops in a bazaar shop a and shop b that sells small decorative items while they sell the exact same stuff shop prices his goods at 40 rupees while shop b has set a price of 70 rupees 

Now you are a middleman who has been engaged by a client to procure these decorative items and this client of yours is willing to pay you 100 rupees for each item. 

The first question I have for you is where is the risk higher that is it riskier to buy from the shop a who is selling at 40 rupees or is it riskier to buy from shop b who is selling the items at 70 rupees.

If you have acted prudently then hopefully you would have picked shop b as the riskier proposition and that's because by buying goods at the more expensive shop you face the chance of a higher loss in case the client refuses to accept the goods or refuses to pay the money for some other reason 

The second question I have for you is where are the returns higher now surely we can all agree that it shops a that gives you the higher return with a margin of 60 rupees while sharp b offers you a margin of only 30 rupees 

So the returns are higher with shop a while the risk is higher with shop b so in case of the shop a higher the returns lower the risk and with shop bit is lower the returns and higher 

The risk is this negative correlation between return and risk that Buffett was referring to in stock and is something that all value investors will vouch for.

So instead of two shops let's look at two companies with the exact same beta company a makes and sells cd-roms and DVDs well company b creates software for fortune 500 companies 

the company a has a lot of debt in its books while company b is conservatively financed company a's management is incompetent and dishonest 

while company b's management is lauded for its business policies and shareholder-friendly governance practices so as an investor which company would you say is more risky company a or company b now this is not a trick question 

So common sense would say that company a is a far riskier enterprise when compared to company b but curiously people who follow the modern portfolio theory will not agree with you 

In fact, they would argue that since both these companies have identical betas they must have an identical amount of risk in them MPT supporters absolutely love beta on the contrary 

Value investors contend that beta does not work in the real world and there are enough studies suggesting that high beta stocks do not necessarily produce high returns and likewise, a low beta portfolio may not be doomed to provide only low returns 

Take for instance a couple of indices that are available on the nifty indices website so in one corner we have the nifty 100 low volatility 30 index which has a beta of 0.76 and in the red corner we have the nifty high beta index with a beta of 1.3 

From a returns perspective, we can clearly see what the many studies have been suggesting the low beta index has outperformed the high beta index by a difference of over 10 per cent per annum which adds further fuel to the beta debate 

The traditional theorists continue to support beta while the value investors are convinced that the understanding of risk should not be limited to just this statistic 

Warren Buffett once defined risk as not knowing what you're doing what he really meant by the statement was that the key to minimizing risk was to be more certain of the key investing factors 

As a matter of fact, Warren Buffett even penned down what those five factors are in his 1993 letter to the shareholders which in our opinion can act as a wonderful checklist to any investor 

The first factor in Buffett's list is the certainty with which the long-term economic characteristics of the business can be evaluated in other words the more predictable a business the less risky 

It is the second factor one should consider is the certainty with which management can be evaluated which is in terms of its ability to execute as well as how well they employ the cash flows, to put it differently if a business is in the hands of a competent manager it is far less risky than in the hands of an ineffective one 

The next factor three is honesty and per buffet, we want to know the certainty with which the management can be counted upon to channel the business rewards to the shareholders rather than to keep it with themselves 

factor 4 relates to an understanding of taxes and inflation which is a way of saying that there is a higher risk in keeping most of one's money in savings accounts 

As these instruments are likely to give you a permanent loss of capital and the fifth and final factor in Buffett's risk framework is the purchase price of the business simply put the more you pay for an asset relative to its value the greater is the risk that you are undertaking 

Now notice here I use the phrase relative to its value what value here means is the estimated price of the asset which in our earlier shop in the bazaar example was 100 rupees 

It's a concept that features prominently in nick sleeps letters where he talks about the price to value ratio that is the price he pays for a particular stock versus what he assumes is the actual value of the stock for instance say a stock is available for 65 rupees 

Your calculations show that this stock is mispriced and should eventually be valued at 100 rupees this means the price to value ratio for this stock is 65 nick's sleep in his bi-annual letters always makes it a point to reveal the price to value ratio of his portfolio and has this to say about it nothing occupies our efforts and time more than reducing the price to value ratio of the partnership we believe this to be the best indicator of latent value and future performance


In all of investing if there are two concepts that are least understood or generally misunderstood by investors then these are risk and the relationship of risk and returns for instance every investment decision will have three things 

In it there will be volatility there will be uncertainty and there will be risk an amateur investor might construe these three words volatility uncertainty and risk as pretty much 

The same thing even though they are poles apart volatility is highly probable uncertainty is plausible and risk is possible it is in this context that investors need a more rounded evaluation of the risk-return trade-off and not be boxed within the popular opinion around high-risk high return or low-risk low return.


Also Read: What is a pattern day trader? Pattern day trader rule workaround

Also Read: How to Identify Stock Trend Changes

Also Read: How many types of mutual funds are there in india

Also Read: How to Build a Portfolio with ETFs

Also Read: How to invest for retirement at age 60


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