Here is a short article that re-examines the myth of High Risk and High Return in Equity.
What is Risk?
Risk defined by Investopedia is “The chance that an investment’s actual return will be different than expected. Risk includes the possibility of losing some or all of the original investment”.
One of the rules that is commonly believed is that ‘higher risk needs to be taken in order to earn higher returns’. This is intuitively obvious. The entrepreneur invests in a new business knowing that there is a probability of failure. The Venture Capitalist invests in a portfolio of businesses knowing that some may give him 30X returns and others may fail.
But lets review this in the context of Equity investments.
In investing, this risk-return rule is true across asset classes. The following graphic Fig 1 illustrates the Risk and Return rankings across different asset classes. Fig 1.
- Here we can see that Cash is the safest asset.
- FDs come next, as they are of fixed duration and fixed returns, guaranteed by a Bank.
- Next come Debt, Bonds, and Endowment Life insurance. Insurance of course is a very high gestation investment product.
- Debt and Bond MFs are products packaged by the Mutual Fund industry into Units.
- Gold and Gold ETFs are another investment option.
- Real estate may come next. It of course varies by location, and commercial/ residential.
- Equity ETFs and Equity MFs.
- Direct equity is the highest risk investment product. It also provides potentially the highest returns of these asset classes.
Note that these are strictly the author’s personal views of the most likely scenarios, and these may vary under different circumstances. The graphic Fig 1 is only a conceptual map, and indicates relative values.
Risk in Equity
Direct Equity as an asset class has two types of Risk:
- Systemic risk is applicable across all sectors. A significant political event, for example, could affect your entire equity portfolio. It is virtually impossible to protect yourself against this type of risk.
- Unsystematic risk is sometimes referred to as “specific risk”. This kind of risk affects a few of the assets. An example is news of a sudden strike by employees, that can only affect a specific stock. Diversification is the only way to protect yourself from unsystematic risk.
Even equity can be split into equity classes, where the risk profiles are different, see Fig 2. Speaking in general, Large Caps are most stable, and have lower risk, next are Mid-caps and next Small caps.
The Risk-Return Relationship
However, once we look at individual stocks for investing, higher risk may not give higher returns.
- The high performing firms in the stock exchange over longer periods are those that are more predictable in terms of growth, costs, investments, new projects and brand strength.
- Example – HDFC Bank over the period of 2009-13 has given fairly predictable 30% YoY growth in profits. As a result investors gave it a superior valuation and it became the bank with the highest market capitalization, even though it was smaller than peers on other parameters.
- Sharp swings for a firm from profit to loss and the reverse too are not seen positively, especially if these happen unexpectedly.
- The ability of growth companies to execute on new initiatives is very important. Such firms need to launch in new markets, create new products or set up new manufacturing plants. Here the track record of such firms in these initiatives is important.
- Monopolies are seen as very positive situations for firms.
- Example – ITC has for several decades dominated the Indian cigarette industry with 75-80% market share. This is a profitable and steady growth industry and so the ITC share has performed well over 10-15 years.
- Typically the fundamentals based approach to the stock market involves projecting financials for a company over 1-3 years, assigning target prices and identifying high potential investments.
- Warren Buffet has taken predictability to the extreme by investing in a bunch of consumer companies (Coca Cola, Procter & Gamble, Kraft Foods, Wal Mart, etc.) where these products are strong brands that are daily consumption habits and so growth is quite predictable over decades rather than years.
The Role of the Equity Researcher
It is the task of an equity researcher to identify, prioritize and assess the risks associated with an investment in a firm. Thus a good equity researcher is actually able to lower the ‘specific risk’ of making an investment, identify potential situations of a company’s future and increase the chance of profitable investments.
JainMatrix Investments approach to Investing
- The JainMatrix Investments approach to investing is to start with a top down approach to first identify the attractive sectors that are likely to outperform the next 1-3 year perspective.
- Next we drill down to the company level to analyse the fundamentals of firms and identify outstanding Large, Mid and Small cap firms. This research is published periodically.
- From this universe of good firms, a few are hand-picked and sorted into Model portfolios. By aligning the portfolios with their risk appetites, we help investors invest better.
Large Cap Model Portfolio
- The objective of the LCMP is to outperform the Sensex and Nifty by 5-10%.
- It consists of 7 large cap shares which are the current or future leaders from attractive sectors of the Indian economy.
- This is a low risk portfolio.
Mid and Small Cap Model Portfolio
- The objective of the MSCMP is to outperform the Mid and Small Cap indices by large margins.
- It consists of 7 mid and small cap firms that are emerging out-performers from identified 3-5 high potential sectors.
- This is a medium to high risk portfolio.
The performance of these portfolios over the last 20-21 months has been excellent –
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See other useful reports:
- Track Record
- The Rationale behind a SELL decision
- Make Equity Investing less tricky: the JainMatrix Eleven