Risk is inherent in any investment. However, its meaning and implication on returns are rarely understood by most retail investors. Terms like high risk, high gain, and no gain without risk have become too commonplace. These terms give an impression that if you take high risk, your gain is high too. If this were the case, everyone would take high risk and earn high returns. However, high risk may involve high losses too, which is often the case. On the other hand, very often, investors come across products marketed and sold as risk-free investment. Though these investments are marketed as risk-free – and they can be called so technically – there is always an amount of risk inherent even in risk-free investment.
Risk in investment
Risk in any investment measures the degree of fluctuation in the returns. Higher the fluctuation, higher the risk. Risk also means the possibility to lose the invested capital. If this possibility is high, the investment is deemed as high risk.
The possibility of losing the investment varies with the fluctuations in the returns. This is the reason stocks are called high-risk investment, because the fortunes of investors may experience extreme swings as the markets fluctuate. On the other hand, bonds are considered risk-free because there is no fluctuation in the returns of bonds. The return is fixed, and hence, they are known as fixed-income securities.
Bonds are of two types – corporate bonds floated by companies and government bonds floated by government or its associated agencies. Corporate bonds are known as low-risk investment, while government bonds are treated as risk-free. However, there are other risks associated with bonds. Let us take a look at the risks.
This is more pronounced in corporate bonds where the company may go bankrupt or may not earn enough to pay the interest promised. While governments rarely go bankrupt or default, there are cases where it has happened in the past. Brazil, Russia, and few other countries have defaulted. However, this is extremely rare. Government bonds can be deemed risk-free on this parameter.
Interest rate risk
Bond investments are subject to interest rate risk. There is an inverse relation between the bond prices and the interest rate. When the interest rate goes up, bond prices go down and vice-versa. When the interest rate goes up, bank deposits look more attractive compared to bonds. Hence, bond prices go down. The reverse happens in case of downward movements of interest rates. Lower interest rate makes bank deposits less attractive, raising the demand for bonds resulting in higher prices.
Inflation is the biggest risk in bond investments. Inflation reduces the real return on investment. The interest rate mentioned in any bond is the nominal return. Accounting for inflation in this return gives the real return. A higher inflation rate means lower real return. In fact, if the inflation is more, the real return can turn negative.
Suppose you invest R1 lakh in a bond paying 8% returns. This means your investment of R 1 lakh will turn into R1.08 lakh after a year. Now suppose the rate of inflation is 6%. This means the amount of goods and services R1 lakh used to buy will cost R1.06 lakh the next year. This means your real returns is not 8% but only 2%. If the inflation rate goes a little higher, the real return can go into the negative zone.
Despite these risks, risk-free investments are popular among big corporations, pension houses, and many government agencies that need to be conservative in their approach. This is still the best choice for the investors with very low risk appetite.
(The writer is is CEO, BankBazaar.com)