Newer forms of risk management

There is one person who is rarely quoted in Financial Circles. He is George Bernard Shaw. He said “Whenever I go to my tailor, he measures me up”. I wish all of us would do it! Once we decide on a particular thing we do not let new facts change our minds. We carry prejudices about “Mr. A is a rogue business man” “T Group is a venerable business house” etc. We may be right or wrong. However we need to clinically analyze all new information and arrive at ‘today’s conclusion’ – are we too lazy to do it? I do not know.
John Maynard Keynes, the economist once quipped when he was accused of inconsistency: “When the facts change, I change my mind. What do you do, sir?”
Well many of us ignore the facts! It is so difficult to tell ourselves (howsoever softly) that we were originally wrong. Oh My God it hurts!

Keep emergency cash, keep long term money in equities or real estate, in the long term equities will give the best returns – are all very old thoughts. Do we need to change anything now? Have things changed so much now? 2008 has seen the simultaneous collapse of the share market, housing market, commodities market – and thus threatening the theory of ‘asset allocation’. We forgot co-relation graphs are nice to see, but difficult to use as a prediction tool! The collapse of the credit markets – even a credit card company would not increase limits!

And to think that the ‘financial economy’ was a huge percentage of the ‘American economy’ you wonder what would happen! So how do you adjust? First, think hard about the risks you face, because they may not be what you thought they were. This has to change how you save, invest, borrow, plan and retire.

Financial Planner: Risk will be rewarded. Risk is measured in your stomach – this is fine, but what it measures is volatility, not risk.
What you should do: You have to be lucky about timing for your goals. If your daughter’s wedding is 18 months away, withdraw fully, if you have the money.

Risk is not just ‘loss of income’ it is also freezing of assets. If you are not happy selling an asset whose price has fallen how will you react? Risk is also freezing of assets!

Whether you’re investing, borrowing, planning a sabbatical, having a child, buying a home, or making a business decision, you know you have to consider risk. But what is risk?

Well, it is surely a four letter word! It is also a difficult question to answer than what many individuals think. Many of us have learned to think of risk as synonymous with volatility. You always thought that technology stocks, bio stocks, pharma stocks – which are product based (and has a lumpy cash flow) are risky. By definition such companies will give sharp ups and downs. However Biocon has given far greater downs – not ups! No serious investor could have made money in Biocon, sorry to say! For years we thought share prices went down and came up. However some changes by SEBI and IRDA will force the financial services companies to dramatically re-look at their business model.
As you now know, the word “long run” part of equity investment is the real risk of relying too heavily on equities. The longest period of negative returns for U.S. equities is 16 years, according to Jeremy Siegel. In India too Investing on a one time basis in 1992 would have meant a 10 year wait for getting your capital back – you would have at least doubled your money in public provident fund.

If you hit a slump in returns at the moment you need the cash, the eventual upside of volatility won’t do you much good. After all like Buffet says to be there first, you have to first be there! If your equity portfolio keeps falling for the first 10 years of your retirement, your mind set will crush you. If you have to live by selling falling assets (remember in 2008 ALL asset classes fell) on in the early years, your portfolio may be insignificant to participate in the rebound. This might lead to an unfortunate situation of running out of money by the time you are 78 – and a potential 12 years to go. Unfortunately, many of today’s retirees are especially vulnerable to today’s downturn.

You shouldn’t run from risky investments just because they lost money – the horse has bolted already. For too many risk managers the risk is after it has happened! In fact the asset class which gives the worst returns (prima facie) is perhaps the best place to invest. Cash looks attractive – but runs the risk of inflation. At this point a SIP in equity looks risky but to me seems to be a better idea than to stick to a bond fund or a RBI bond kind of investment. The Indian equity market has really rebound but the signals from the real economy are not too great.

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One Response to “Newer forms of risk management”

  1. Subra, perhaps you’d like to add the following – unless you invest money in a hard-core business (against investing in the market – capital, real-estate or commodity or whatever), your returns on investment aggregated with those of other participants is a ‘zero sum game’ measured between 2 specific points in time (adjusted for inflation/money supply)- hence the returns you generate are a function of your emotional maturity and ability to take ‘contrarian’ calls. When we address the aspect of risk, it is always assumed that it is due to external factors, what is ignored is the risk component arising out of an investors decisions! We only realise this after the damage is done. In the world of investing ‘poikilotherms’ or ‘cold-blooded’ creatures fare better!

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