The Money Hans’ Post

Transcript

So what is risk? When we crossed the road we expect that the drivers will stop for us because they are trained. Hopefully they have lots of experience. But there's a possibility that they were not trained and they're not experienced, or that they are those things, but for some reason they might get distracted and they're not able to stop in time. So even though we have crossed the road many times before, we run the risk of getting hit by a car. I know, Morbid. OK, let's take another example. Say we eat at a restaurant all the time. We know that the chef is very good and they're very careful. And therefore there's. Less chance of food poisoning, but it's not no chance. It is possible that on a given day that you went there that something goes wrong. So sometimes even with the best of effort, there is that chance, that small chance that something bad could happen or something different or unexpected could happen. That is risk. And it's not like we're not taking risks in other parts of our life, for example, when we're choosing a career. Or when we're choosing a life partner, we may do our due diligence, we even have this gut feel, but that is no guarantee that they will turn out to be like we expected it to be. So that's risk. We take risks all the time. It's just that we hopefully rely on some metrics, some experience, whether it's our parents or seniors or or we do our due diligence, but that risk of something unexpected happenings is still there. Same thing happens with investments. Let's take a look. So Robert, finance point of view, the biggest risk is not being able to meet your goals current or future. But from an investing point of view, the biggest risk is actually inflation risk. So when we are saving and we put our money in savings accounts or or even fix some deposits, the risk is that the future value of our money is not the same as current. So basically the value of our money has gone backwards. We are not able to buy the same goods and services with the same amount. That's inflation risk. Why does inflation happen? Well, that's a much bigger question. For now, let's just understand that the economy moves in cycles in business cycles, so. GDP, and therefore interest rates and inflation also move in cycles. While the media lets us believe that the government controls this, actually they don't. They usually. The central bank and government, through monetary policy and fiscal policy, are always catching up with what's already happening in the economy, which in turn is actually collective psychology anyway for another day. But the point that you need to know is that closely related to inflation risk. Is interest rate risk. So there are times when interest rates go up and their times when it go down. Over the last 30-40 odd years, interest rates have broadly been coming down in developed markets in India, we've seen relatively high inflation and interest rates in the 80s. But again here also we have been seeing both of these coming down. What does that mean? Interest rates actually lead to how assets are priced, so when they're coming down. It's good for assets when they're going up. It's bad for assets. Also, interest rates dictate how businesses are able to invest in capital investments and also in running costs to interest rate. Risk is also a big one. Speaking of interest rates affecting values, let's understand how valuations work. Basically, if I want to value something, I've put a whole bunch of assumptions into a spreadsheet and say this is my opinion of what it's worth. But here's the thing, it's just my opinion. And if I own it, I will value it high and if I want to buy it from you, I will value it low. But frankly, opinions don't matter in the end. The buyer and seller have to get together in a market, negotiate and then settle on a price. The price at which the transaction happens. That is the market price. So when something is overvalued or undervalued, that's just your opinion. Anyway, so the market price is what transactions actually happen at. If it is for one asset, it's called price risk to the price being sort of higher or lower than what you thought it was worth its price risk. When it's for whole market like the stock market, it's called market risk. While while price or market risks are real in that that's what the market is offering or that's what somebody else is offering, you don't have to sell at that price. If you can afford to hold on to your asset, you're most welcome to believe that it's worth much more, OK? And and you can sell it another day when the price is higher than what it is today if your asset is unique. Like say a property or something you can choose to negotiate separately over the counter. Or someone who has a unique sort of need, you can negotiate with them and you can sell it to them. And if they if they check bounces, that is counterparty risk. Counterparty risk is basically when someone doesn't honor their commitment. And you might say, well actually I'll find some good other parties and who needs a market? OK. Well, actually not so fast. Imagine now the market is closed. How would you even go and find a buyer? And if the market is closed and you're not able to sell your investments when you need it or your assets when you need it, that is called liquidity risk. It doesn't mean that their asset is worthless. It just means that currently there are no buyers in the market because the market is not open or somehow there's an issue with the market now that we like markets we understand the prices for. Businesses fluctuate, OK. It could be related to factors related to that business, say it's a banking stock or a paint stock or something. Or it could be prices just fluctuate because the economy in general or that sector or interest rates or whatever. OK. It could be a bunch of reasons. So stock prices fluctuate. What about bond prices? Yes, of course they fluctuate based on interest rates and inflation and the economy a little bit. But there is one other reason. So if the bond is not of a government but actually a corporate bond, so a company or business has issued the bond. The business, unlike the government, cannot print money. So there is a chance that somebody perceives that the business is not doing well and therefore there is a possibility of that business not being able to meet their interest rate payments or their capital repayments. That is credit risk. In fact, there's actually 2 aspects. One is there are these agencies called credit rating agencies. They are the ones who go into the business and do a detailed due diligence and they give them a credit rating, a creditworthiness rating, basically. And they might say business A might not be able to meet their commitments. And because business B is actually in the same sector, it might actually affect the perceived. Credit worthiness of this other business. So credit risk is actually not just the fact that that business may not be able to meet their commitments, but the perception that that business or other businesses might not meet their their obligations. So there's credit risk and there's also default risk. Default is when you actually default. Credit risk is when the perception is that you might default. So now we've talked about a bunch of investment risks. We've talked about inflation, interest rates, price, market liquidity, counterparty credit default. Bunch of risks, right? So here's the thing. Yes, these are risks you take on, and yes, you should get higher returns for them. That's the theory. But like all things in finance, theory doesn't always translate to practice. So you will see charts like this that show a risk and return in a straight line 45�� going up. So higher risk, higher return. But in practice the charge should actually look more like this, which shows that for every asset class there's actually a range of outcomes that could happen, while the average means higher return for higher risk. It is possible that you get a different outcome. For now, the biggest risk that you face is that your advisor or whoever is helping you with investments doesn't understand these risks. So when they tell you that there is no risk in this investment or very little risk running a mile. However, if they sit down with you and properly explain all these risks to you, then we're getting somewhere and be kind to people. Will say I don't know because frankly, measuring these risks is hard. It's hard because. As humans, we always want to base our future predictions based on past performance. And as we found out in more recent years, the past is not always a good guide to future performance. In fact, there's always a first time. So be kind to people who say, I don't know, now let's talk about how to manage the risks. Just like any other problem in life, the first step is to acknowledging that we have a problem, so we acknowledge that we have these investment. Risks and ideally we should have a probability and an impact on. Of each of the risks. In a table. Your advisor should be able to help you with that. If not, we will be putting out future articles, so keep an eye out. Then there are four ways to deal with risks. One is avoid second except, third, mitigate for transfer. So we may want to avoid risk, but actually it's not possible because if we put all our money into what we think is safe, like gold or fixed some deposits, we are actually taking on inflation risk. Remember that one, the one that you won't be able to meet your future value and goals so. You can't really avoid apart from maybe a small part of your portfolio. Now let's talk about mitigate risks. So. To mitigate risks, you should do research. You should do due diligence. You should really do your homework and get your advisor to do the homework for you as well. And you do homework on the advisor so that you really try and mitigate the risks that you're taking in investments. The other way to mitigate is to diversify. Diversify within the asset class and also across asset classes, so make sure that your investments are spread out across. Fixed interest, which is fixed, some deposits and bonds and so on, Equities, gold, real estate and anything else you can find. So make sure you're diversified. That, by the way is called asset allocation. Definitely the best thing you can do. Now, how much diversify is another question, which we'll discuss in another episode Now except. So remember that market risk, market risk is basically the risk that the whole market being the stock market can go down. Usually one asset class goes down, the other ones are OK. But as we saw last year in 2022, it is possible that all markets or most markets go down together. Yes, it happened, it was improbable, but it happened. That's why anyone telling you that it doesn't happen doesn't know what they're doing anyway. The point is you accept it. So that's why I recommend putting some money in fixed, some deposits in cash, especially your emergency fund, so that you actually have time to sail through and wait till all your investments. Cover The last one is transfer risk. That's slightly more complicated, so we'll discuss that another day as well. So there you go. Today we discussed risk. We discussed what risk is, which is basically the future turning out to be different from the past. We discussed different types of investment risks. We also discussed market risk and then we discussed how to manage these risks. Except avoid. Mitigate. Basically, investment risks are no different to life. We just have to be mindful. We have to be aware of what they are and then calmly deal with them. Just like we calmly deal with all the problems in life. And that's how we learn to be money mindful. See you in the next episode.