Mumbai, 13 February, 2019 (GPN) : Risk in simple terms can be defined as exposure of something valuable to danger, harm, or loss. More specifically to financial markets there are several types of risks which need to be considered such as Market risk (Equity markets considered to be more riskier than Debt markets), Credit risk (Sovereign or Government bonds considered to be safer than Corporate bonds) and Interest rate risk (Short term bonds carry less risk than long term bonds). However, everything about risk can be debated, to start with whether it is a good or a bad, whether it should be sought out or ignored, and how it should be measured.
A risky asset is any asset that carries a degree of risk, while a risk free asset carries a lowest degree of risk. Any assets cannot just be categorized into Risky asset or a Risk free, but it can be though off as a scale where on one end there is asset with extremely high risk and at other end there is riskless asset.
Majority of risk and return models assume that there is a riskless asset which can offer a guaranteed return. However in all practical terms there is no such asset class. Most of the models use Government bonds (India, US etc.) as risk free rates, but key assumption here is that government will not default and even if promised coupon is paid, sometimes inflation can lead to negative real returns.
There is lesson to be learnt from the 2008 Global Financial Crisis (GFC), that there are absolutely no Risk Free Assets left and investors will have to settle for the least risky asset class, during the period like this.
Equity investing can expose investors to various risks, which can emanate from variety of sources, it has to be noted that some of these risks are relatively difficult to estimate and deal than others. Certain risks can be addressed via portfolio diversification and it will benefit till assets in portfolio are not perfectly positively correlated. Now this can lead to an ever-growing debate as to whether a concentrated portfolio is better vis a vis a diversified one, best answer to this would be that it should be driven by an investor’s investment belief. However, from perspective of risk measurement for an investor, it should be driven by investment objective and time horizon.
In bull markets, investors often ignore risks, driven by the premise that equity always win in the long term. However, there are risks involved in equity investing and that’s why there is a risk premium attached to investing in equities, relative to risk free assets. Opposite is true during periods of high market volatility, investors often are consumed by risk, which is natural. However, objective in investing is to earn the highest returns, with risk operating as a constraint.
There are various tools and techniques available for risk measurement, risk measurement will depend on the investment philosophy, portfolio type etc., an investor can pick and choose the risk measurement tool accordingly.
In the end, whatever risk measure is chosen to assess investments, it should earn returns which are commensurate with the risk taken.
About the Author:
Varun Agrawal, AVP Credit Analyst
Varun Agrawal is a Chartered Accountant from ICAI and an MBA from IILM. He has also cleared Level 2 from CFA Institute, USA. Varun has over 10 years of work experience in Credit & Equity Research, Investment Banking and Corporate Finance.. He has been associated with organizations such as ICICI Bank, CapGemini Consulting (India) and Royal Bank of Scotland. Varun joined BOI AXA IM in 2011 as a Senior Analyst.