Risk is a four-letter word, and not many get it, though!!
When will you allow your child to cross a road?
Take your time to answer this.
Knowing the 'risk' is better than asking what will be the return
Most of the people would respond whenever the child is ready.
It’s the other way round, “whenever you are ready”. Yes, think about it, people who live on the footpath, you will see their kids on the road all the time, irrespective of their ages.
The first perspective is that we all are different, and we perceive RISK differently.
The academic world defines risk from the willingness and ability to assume risk. Willingness is the behavioural aspect of a person’s comfort to accept risk. At the same time, the ability to assume risk depends upon the net worth of an individual. The lower of the two should be taken as a ‘risk profile’.
Interestingly, there are free and unpaid tools to assess this. I have a view that behavioural factor is much more critical in determining the risk. This assessment requires knowing a person more than a simple questionnaire. Interestingly, knowing yourself is even more crucial; you will make better decisions.
For example, a lot of people claim that investing in the stock market is RISKY. The same set of people buy a house by taking 75-80% of housing loan. How is that not risky? We have seen that many people lost their jobs during the pandemic and had to face massive hardships. They did not have any money for the EMIs. The risk was there, but the optimism overpowered it.
Let’s look at the risk aspect at asset class levels:
Indians have always favoured bond investing. To me, keeping your money in a fixed deposit with a bank is also a kind of bond investing. Fixed deposit may be the simplest way, and it is followed by treasury bond investing (RBI bonds maturing in 90 days), 3-5 years government securities and ten years plus duration securities.
The probability of losing money in an FD or a liquid fund, or a money market fund is low. Rest all will have some level of risk. However, even an FD will have some risk. Remember the case of PMC bank!!
Indians have a special place for gold in their heart. However, being an international asset, the prices are driven by global markets. Gold will increase in value whenever equities are not seen as a safe asset category. Therefore, gold is a good hedge against equity. However, on its own, gold is not a ‘risk-free’ asset.
3. Real Estate
Thank God we do not have daily quotes of real estate. If that happens, a lot of people will have heartaches. Real estate has created a lot of wealth for the previous generation. The new generation has moved away because they did not have a great experience with real estate investing.
Real estate is a long-term asset and should be seen from a 15-years perspective. Additionally, different forms of investing will impact your performance. It is rather difficult to forecast what will happen in 10-15 years around the land which is 500 km away from a big city. It may develop, and the land price will shoot up, or nothing happens.
Real estate investing in an apartment is not an investment. The best-case scenario is meeting the inflation, and that’s about it. A better way would be investing in land. Someone who understands the real estate cycle well is positioned right to gain.
Real estate allocation is high-risk and speculative.
There is enough written on the subject around equities being high risk.
“Risk comes from not knowing what you are doing” – Warren Buffet
A lot of investors don’t get this right. In the current bull market, everything is going up. Well, that’s the nature of a bull run.
“Only when the tide goes out to do you discover who's been swimming naked.” – Warren Buffet
Banks, auto and commodities are driving the current rally. These are cyclical businesses, and the party must end someday.
However, quality businesses do not have to worry about the tide settling down. These businesses are fully covered.
So here is a low-risk strategy to invest in equities over the long term.
Just like God has made principles for nature, similarly, some principles would make a business enduring and long-lasting. As far as the company can grow, the worth of investment in the industry will also continue to grow.
Criteria 1: Sales Growth
A company must have grown its sales by at least 10% every year for the last ten years. We assume that if the inflation is around 7% in the economy, the company has generated at least 3-4% in real terms.
Criteria 2: Return on Capital Employed (ROCE)
A profitable company will be able to generate cash flows. This cash flow is either distrusted by the shareholders or invested back. These are the elements of value creation for the shareholders.
Criteria 3: Debt to equity
Firstly, you need to exclude financial stocks, and secondly, you want to invest in companies that are generating cash flows, but that cash flow is not just used to service the debt.
Criteria 4: Market capitalization
You don’t want to focus on less than Rs 100 crores market capitalization of a company —cleaning up companies that are less than Rs 100 crores might be time-consuming and not a worthwhile process.
Here is a criterion you can use to screen companies:
1. Sales 10 years > 10%
2. ROCE 10 years > 15%
3. Debt to Equity < 1
4. Market capitalization > 100
The shortlisted companies will have a short-term volatility risk but, if studied well, can position your portfolio for a snowball effect.
“In the short run, the market is like a voting machine. But in the long run, the market is like a weighing machine.” - Benjamin Graham