| Does greater risk mean greater return ? |
Seems to be the commonest of all misconceptions. Most investors
believe that risk and return go hand in hand, i.e.,the more risk you are willing to take,
the more returns you are likely to earn, and conversely, the less risk you are willing to
take, the less returns you are likely to earn. Most investment professionals also agree
with this statement. The same opinion is held by most academicians.
So, is taking higher risks the only way to increase returns. If yes, then why is it that
horse betting pros who seek risk as well as the so-called commensurate rewards that go
with it, often lose? Why then is it the prudent investors, who shun risk, always win? If
you read buffetology-the art of investing the Warren Buffet way-The exact opposite maxim
of higher risk means higher return is true with value investing. If you buy a ruppee for
60 paise, it's riskier than when you buy a ruppee for 40 paise, 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.
One of the many unique and advantageous aspects of value investing is that, the larger the
discount from intrinsic value, the greater the margin of safety and the greater potential
return when the stock price moves back to intrinsic value. Contrary to the view of modern
portfolio theorists that increased returns can only be achieved by taking greater levels
of risk, value investing is predicated on the notion that increased returns are associated
with a greater margin of safety, i.e., lower risk.
So in order to compound your principal at a satisfactory rate, you don't have to seek
risk. Rather you have to run away from risk! However risk in this context needs to be
defined somewhat differently. Beta, which identifies risk with, the past relative
volatility of a stock as compared to that of a large universe of stocks can be calculated
precisely, but to identify it with investment "risk" is somewhat incorrect. Beta
measures volatility and volatility is not the same as risk. So, according to this theory,
if a stock drops sharply as compared to the overall market, it becomes "riskier"
at the lower price than it was at the higher price! The term "risk" to an
investor ought to mean the possibility of loss. The trick in this is getting the price
paid-right. For instance availing of the recent dip in the market if you buy Tata Tea,
Tata Power etc at these prices, then you have entered at a price which gives you a higher
chance of appreciation therefore lesser risk of loss.
So, though you may not be able to get in at the bottom and get out at the top, it does pay
to hunt for bargains. If you have ever shopped for quality merchandise at a discount, you
know that, with some effort, you can often find a real bargain—outstanding value at a
low price. Value investors seek securities that seem to be underpriced relative to their
intrinsic worth or future prospects. They hope that others will eventually recognize an
undervalued security's true worth, causing its price to rise. When such a security appears
to be fully valued, the typical value investor will sell it and search for another
bargain, starting the cycle over again.
However do not mistake low stock prices for "value". When a stock sells at a
discount, there is often a good reason, and the investor should be wary. The philosophy of
value investing as method lowering investor risk and at the same time maximising his
returns is to pin point cases where the discount is unwarranted, and that's where the
value investing concept comes in. For instance a stock which has a relatively low P/E, low
price/book value, and low price/cash flow ratios and high dividend yield may be a value
situtation.
A principal advantage is that careful stock selection will limit the overall downside risk
of a stock portfolio over time for two reasons. First, a stock that is already
cheap—buying a ruppee for 50 paise, as investment guru Warren Buffett puts
it—should be less vulnerable to market downdrafts than one that is fully priced.
Second, value situations may offer above-average dividend yields. This is more likely the
case with larger companies, whereas small companies tend to pay very few dividends, if
any. Since dividends always contribute positively to total return, they can cushion a
falling stock price.
But as is with every risk minmising theory one cannot buy-and-hold. You have to constantly
recycle stocks as their value is recognized, which means constant research and monitoring.
Also change your investment strategy with the market swings so as to ride waves, and cream
the profits. For instance when the interest rates and inflation are relatively lower then
growth stocks predominate as these conditions encourage higher valuations for the future
earnings streams of these companies. Rising interest rates, a slowing economy, and weaker
earnings growth make value stocks - many of which have steady earnings prospects - more
attractive. A wide or extended disparity between growth and value stocks suggests that the
odds are against a continuation of the trend. Value stocks tend to outperform when
investors anticipate a new cycle of economic and corporate profit growth, since the
earnings of economically sensitive companies can rise sharply from depressed levels.
Rising interest rates can also change investment cycles, because investors may become less
willing to pay large premiums for future earnings growth and may look for less richly
valued, lower P/E stocks.
Remember no one investment strategy can guarantee results, however, looking at the overall
market scenario an investor must fine tune his strategy to lower the risk and reap the
reward.
Aru Srivastava
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