8/9/2019 A Calculated Risk

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A calculated risk

Only those who risk going too far can possibly find out how far one can go- T.S.Eliot

'Investing is risky business'We have all come across this statutory warning or have learnt it the hard way while investing in the

stock market. Let us take a step back to understand what is 'risk'.

The word is commonly used to describe the chance of a loss.

Chance: the Webster Dictionary defines this word as 'something that happens unpredictably withoutdiscernible human intention or observable cause' In other words, risk in the financial context stands forthe uncertainties associated with future cash flows.

We have learnt earlier how savings transform to 'Risk Capital'. We have taken a hard look at equityrisks and figured out that 'Khel risky hai'.

But did you know that 'Risk' owes its origin to the Italian word risicare that literally means 'to dare'?Risk as a verb is used to imply 'taking the chance'. In other words, as Peter Bernstein observes in theintroduction to his magnum opus 'Against the Gods',

'... risk is a choice rather than a fate. The actions we dare to take, which depend on how free we are tomake choices, are what the story of risk is all about. And that story helps define what it means to be ahuman being...'

If 'risk' is all about choices, it is time to know how to factor this in our investment decisions.Let us learn how these choices are made from the actions of Mr. Savvy Investor. Needless to say he isthe smart guy who makes the smartest choices when it comes to investing.

Mr. Savvy Investor has Rs1,00,000 to invest. He has two investment options.

The first option is a government bond that pays an interest of 10% per annum for the next threeyears.

The second option is investing in a particular stock. A leading analyst expects this stock to go up by

just 2% in the first year as the company is still expanding capacity. But he expects the stock to gain28% in the next two years.

Mr. Savvy Investor fishes out his pocket calculator and gets down to business.

The bond option is fairly easy to calculate. His Rs1,00,000 investment would be worth Rs1,30,000 inthree years. In other words, it would fetch him a return of 30% in three years.

He works out the returns for the second option.

His investment would be worth Rs1,02,000 at the end of the first year. A gain of 28% over the nexttwo years means that his investment would be worth Rs1,30,560. Thanks to the 'power ofcompounding. his 2% gain in the first year will earn a return too. In the end, he would earn a 30.56%return in three years.

Two investment options with almost the same returns in three years. Which option does Mr. SavvyInvestor choose?Our Mr. Savvy Investor chooses to invest in the government bond.

It is easy to figure out why Mr. Savvy Investor has chosen the bond option.

Though investing in the stock meant marginally higher returns. There were lots of uncertainties.Remember, investment in the stock is based on expectations, expectations of a leading analyst, in thiscase. On the other hand, the government bond gives a fixed return with no question of a default.

What if the analyst got it al l wrong? For all you know, a competitor might increase capacities and killthe market in the second year. Hence, the expected 28% appreciation might actually turn out to be adecline! As Murphy's law states 'If anything can go wrong, it will go wrong'.

Hence, Mr. Savvy Investor does not even bat an eyelid while deciding to invest in the governmentbond.

Let us now add a twist to the second investment option and see if it makes a difference to Mr. Savvy

8/9/2019 A Calculated Risk

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