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 ictionary de!ines this word as 'something that happens unpredictably without discernible human intention or observable cause' In other words" risk in the !inancial conte#t stands !or the uncertainties associated with !uture cash !lows. We have learnt earlier how savings trans!orm to '$isk %apital'. We have taken a hard look at e&uity risks and !igured out that ''hel risky hai'. (ut did you know that '$isk' owes its origin to the Italian word risicare that literally means 'to dare') $isk as a verb is used to imply 'taking the chance'. In other words" as *eter (ernstein observes in the introduction to his magnum opus '+gainst the ,ods'" '... risk is a choice rather than a !ate. The actions we dare to take" which depend on how !ree we are to make choices" are what the story o! risk is all about. +nd that story helps de!ine what it means to be a human being...' I! 'risk' is all about choices" it is time to know how to !actor this in our investment decisions. Let us learn how these choices are made !rom the actions o! -r. Savvy Investor. .eedless to say he is the smart guy who makes the smartest choices when it comes to investing. -r. Savvy Investor has $s/"00"000 to invest. 1e has two investment options. The !irst option is a government bond that pays an interest o! /02 per annum !or the ne#t three years. The second option is investing in a particular stock. + leading analyst e#pects this stock to go up by 3ust 42 in the !irst year as the company is still e#panding capacity. (ut he e#pects the stock to gain 452 in the ne#t two years. -r. Savvy Investor !ishes out his pocket calculator and gets down to business. The bond option is !airly easy to calculate. 1is $s/"00"000 investment would be worth $s/"60"000 in three years. In other words" it would !etch him a return o! 602 in three years. 1e works out the returns !or the second option. 1is investment would be worth $s/"04"000 at the end o! the !irst year. + gain o! 452 over the ne#t two years means that his investment would be worth $s/"60"780. Thanks to the 'power o! compounding. his 42 gain in the !irst year will earn a return too. In the end" he would earn a 60.782 return in three years. Two investment options with almost the same returns in three years. Which option does -r. Savvy Investor choose) 9ur -r. Savvy Investor chooses to invest in the government bond. It is easy to !igure out why -r. Savvy Investor has chosen the bond option. Though investing in the stock meant marginally higher returns. There were lots o! uncertainties. $emember" investment in the stock is based on e#pectations" e#pectations o! a leading analyst" in this case. 9n the other hand" the government bond gives a !i#ed return with no &uestion o! a de!ault. What i! the analyst got it all wrong) :or all you know" a competitor might increase capacities and kill the market in the second year. 1ence" the e#pected 452 appreciation might actually turn out to be a decline; +s -urphy's law states 'I! anything can go wrong" it will go wrong'. 1ence" -r. Savvy Investor does not even bat an eyelid while deciding to invest in the government bond.

Let us now add a twist to the second investment option and see i! it makes a di!!erence to -r. Savvy Investor's choice. The leading analyst e#pects the stock to go up by /42 this year as the company has !inished e#panding its capacity si# months be!ore time. 1e also e#pects the stock to gain 452 in the ne#t two years. -r. Savvy Investor does his calculations to !igure out that his investment" in this case" would !etch a return o! <6.<2 in three years. + good /6.<2 more than the government bond. Like earlier" the uncertainties still remain. 1owever" since -r. Savvy Investor earns <6.<2" he can still take the chance. I! the stock !ails to go up by 452 in the ne#t two years and instead goes up by 3ust /=2" he will still make a return o! 6/2; In other words" the higher return provides a margin o! sa!ety. 1ence" the higher rate o! return over the government bond !or the same period makes -r. Savvy Investor pre!er the second option o! investing in the stock. What made him go !or the second option) The /6.<2 e#tra return over the government bond. This 'e#tra return' that induces our -r. Savvy Investor to choose the more uncertain investment option is called '$isk *remium>. + !inancial te#tbook will tell us that $isk premium is the 'reward !or holding a risky investment rather than a risk-!ree investment. The e#tra return that the stock market or a stock must provide over the risk-!ree rate o! return to compensate !or the market risk is called >E&uity $isk *remium>. In case o! -r. Savvy Investor" the e#tra return o! /6.<2 over the risk-!ree 602 rate o! return on the government bond de!ines his >e&uity risk premium> 1ow do you determine 'e&uity risk premium') What is the right premium to settle !or) What is '(eta') -ore o! this ne#t time as we brace ourselves to risk the stock market and brave the uncertainties. +s one great statistician wrote" >1umanity did not take control o! society out o! the realm o! *rovidence...to put it at the mercy o! the laws o! chance.> Copyright 2002 Sharekhan.com & SSKI Investor Services Pvt. Ltd. All ights ?@(9 A.? span html?B Copyright 200! Sharekhan.com & SSKI Investor Services Pvt. Ltd. All ights eserved. eserved. ivine