Equity investing: More a science than a gamble

Are stock market investments risky? You bet they are, but perhaps not as much as Mr Sanjay Deshpande, a seasoned life insurance agent, fears. “Investing in stock markets is like gambling; it’s way too risky! You never know if your money will ever come back,” he declared, when asked about the quantum of risk he associated with equity investments.

But quiz any trader or investor who has made money in the markets, and he or she would vouch that it is this very same “risk” that, adds to the thrills and spills of investing. After all, isn’t the stock market the only place where one can double or even treble money in no time, they said.

So, what exactly is risk? Are equity investments really ridden with high risks? Are returns in the stock markets only a game of chance? Thankfully it is neither. It is, instead, a developed science involving various checks and filters that investors can and do use before committing funds to a particular stock or company. A look at some myths on markets, risk and returns.

More than a mere gamble


Though from investment to speculation it is only a short step, it still would be grossly wrong to categorise investments as a mere gamble. That’s because, in gambling while the players leave the result entirely to chance, equity investing, on the other hand, involves taking calculated risks, well-backed by an analysis of the company’s fundamentals, industry dynamics and valuations.

“But if it is not gambling, how do you explain the losses my friends suffered on the investments they had made in January 2008?” quipped Mr Chatterjee, a retired school headmaster. Well for one, note that investing in equities is always a trade-off between the risks you take vis-À-vis the returns you expect to make over the course of time. Remember that January 2008 coincided with the market trough and so the investments made then, at the peak, certainly would have shrivelled with the subsequent correction.

This brings to fore the risk of getting the timing right too. Investors may, therefore, also need to budget for this.In that too, if Mr Chatterjee’s friends had put money in stocks that enjoyed a promising business outlook, sooner than later, with the markets trending upwards now, their complaints would die down; provided, of course, that they remained invested in the stocks.

This certainly would never be the case with gambling, where returns depend solely on whose side lady luck plays.

Volatility kills returns


It is in this context that the importance of maintaining a long-term perspective cannot be overemphasised. For instance, while volatility in returns over the short-term is almost congenital as far as stock market investments are concerned, it does become a rewarding experience for those who stay put for the long term (assuming investment choices are made diligently).

Besides, aren’t investments per se supposed to be made with a long-term perspective!

For instance, investors who had ill-timed their entry with the market peak in January 2008 would now be witnessing a reversal in losses.

And for the ones that had invested in select stocks from the automobile and FMCG sectors, the current rally may even have given profit booking opportunities; some FMCG and auto stocks have treaded well beyond their January-08 highs. So, while it is foolhardy to expect your portfolio to be in the money all the time, note that over time it does tend to move towards greener pastures.

high Risk= high return?


Agreed, risk and return are intertwined but a high risk doesn’t really guarantee a high return. Risk, which indicates the likelihood of loss or less-than-expected returns, isn’t really as great a peril (as it is made out to be), provided investors diligently investigate the prospects of the company they are planning to invest in.

Continuous monitoring of developments thereafter is also a must so long as they remain invested in it. Though equity investments are high in the pecking order in terms of risk profiling (when compared with other avenues such as debt and bank FDs), there have been instances when their returns have paled in comparison.

Equity investments in 2008, though tagged ‘high risk,’ returned negatively whereas the low-risk avenues such as FDs and bonds yielded better (in the range of 6 per cent to as high as 12 per cent in some cases).

Within the stock universe too, the risk element associated with a particular sector, market capitalisation category or even the management bandwidth would differ. For instance while in the peak of the bull run, companies with aggressive expansions were perceived to be of average risk, their risk profiling was suddenly upped when the liquidity scenario turned on its head a year later, driven by the recessionary trends in the global and domestic economies. Real-estate companies are a classic example in this context.

While 2007 saw investors swarm these stocks, enamoured by their huge land banks and undying demand, a year and these stocks faced the one of the worst desertions ever with some losing as much as 90 per cent from their peak. On the contrary, lower-risk defensives from the consumer goods, pharma and auto sectors scored relatively better.

So, even as high risk doesn’t really promise high returns, the corollary is also true — low risk doesn’t always yield low returns.