A poem on Risk

There was a young girl of Nic’ragua,

Who smiled as she rode on a jaguar,

They returned from the ride,

with the young girl inside,

And the smile on the face of the jaguar.

- Salman Rushdie

Know the 4 Dimensions of Investing

Investing and analysing investment options can seem burdensome, tiring, boring, confusing, hair-splitting to know everything about it before committing your money to it. Irrespective of what the brokers, sales guys, agents try to push to you as an excellent opportunity for you and your loved ones, it is important to know that they have an inbuilt interest in selling things to you and you have to do your own due diligence. Doing your own due diligence is often spoke about, but some of you may wonder what does this mean and how do you do it.

There are essentially 4 dimensions to understand any investment:

1. Return/Potential Return

I say return/ potential return and not just return so that you are not overly swayed by the superb past returns of an investment, but realise that not all investments will repeat their super duper track record time and again. There may have been a time and environment where something really made great returns, but this time and environment may well be very different. 

A plot in a far away village may not give you a great return on your investment without nothing new happening. But, once it is known that an international airport will be coming in the area, the investment may have great returns. And once all the development is done, the return on investment may not follow the run you saw during the days when the news of the airport was coming. Similarly with stocks. There are good times and great times for companies depending upon a myriad of factors such as demand for the product/service, cost of making things, saturation of product usage, etc.

2. Risk & Return

Each investment has a certain risk to it. Even Govt. owned companies and their shares/bonds have some risk in it. Nothing is risk free. Sometimes the risk is on the return, while on some others, the risk is on the capital deployed itself. One has be aware of the risks and consider the return on the investment proportionately to the risk involved. Derivatives are more riskier than Stocks which is more riskier than fixed deposits/bonds/gold.

Do remember that sometimes even a less risky investment can cause a major loss compared to a higher risk investment.

3. Liquidity

This involves multiple things and is very important but unfortunately not given much importance by many people. Liquidity refers to how fast can you to convert the investment to cash whenever you need it. Another related aspect to liquidity is whether the investment can be used as a collateral against which you can get a loan. Certain investments cannot be given as collateral and no loan can be obtained against them. E.g. Bonds, Fixed deposits in some NBFC (Non Banking Financial Company)s. Some investments may have a lock in period which will limit the ability to sell the investment. Certain bonds have a lock in period before which you cannot trade it in the market. Sometimes, holding a stock/bond that is not widely traded also brings about liquidity problems while trying to sell it.

4.  Tenor

The length of the investment period. At the end of the day, you will need to match the investment tenures to the life's various goals. No point in investing in a 20 year investment that is locked if you don't have money for your other urgent goals.

All investment avenues would have the above mentioned 4 characteristics. You should know these 4 aspects of your investment and competing investments before you make a decision to invest in one based on your life's goals and risk apetite.

Lifes' risks in the new world

Any uncertainty leads to risk. There are many types of  Risk. Many are non-financial and related to lifes' uncertainties. In a continously changing and evolving world, new uncertainties arise and the same old uncertainties have more (and seldomly, less) risk than the previous decades/generations. When the old parameters to measure risk are inadequate, inaccurate and inappropriate, how can one measure risk? Risk is always measured with respect to certainty just like dark is defined to the relativeness of light. And when certainty itself (the reference point) cannot be defined/yet to be refined, how do you measure risk? At a macro level, it is possible to say that the risk is more in the new world compared to the old world, but measuring it against another new world situation is impossible. And when risk cannot even be known accurately and measured, how can you successfully hedge the risks? Having huge exposures and open positions may have upsides even in life, but the downside risk is huge and scary.

One unique aspect about each of lifes' risks unlike financial risks are that you cannot be semi-hedged. You are either fully covered or stark naked!

Basis risk

"Being hit by basis risk makes you feel cheated."

For the common public, basis risk is a risk of not getting what you paid for or the risk of getting something not matching to your specifications or what you had in mind.

Risk and uncertainty

"One can have uncertainty without risk, but not risk without uncertainty." Uncertainty: The lack of complete certainty, that is, the existence of more than one possibility. The "true" outcome/state/result/value is not known. Risk: A state of uncertainty where some of the possibilities involve a loss, catastrophe, or other undesirable outcome.

CAPM

What the heck is Capital Asset pricing Model? In my simplest understanding, it is the measure of the rate of return per risk taken. Which do you choose? Option A: You can get a 40% return for a certain amount of risk taken. Option B: You can get 20% return for the same amount of risk taken. Answer: Any rational [one of the assumptions of CAPM model :) ]person would choose option A over option B. The CAPM allows you to represent this. The per risk taken is the risk free return (Rm - Rf). For actual market risk (beta=1), the expected return is the market return.

But what if the expected return of an investment is more than the market return for the same market risk? Will you go for it? Of course, you should. The point of this investment in the CAPM graph will be above the security market line(SML). The SML is the line depicting the expected market return for every value of market risk (If the risk is less than the actual market risk, beta is less than 1 and greater than 0. if the actual risk is more than the actual market risk, then beta is greater than 1. And yes, beta can be negative when the asset price varies inversely wrt the market movement).

If an investment is below the SML, it means that the investment is not worth the risk taken and it is possible to invest in the market itself and get a better return for the same risk. One of the disadvantages of CAPM is that it measures standard deviation as a measure of risk. There are better ways to measure risks like the coherent risk measure.