- T.S.Eliot
The word is commonly used to describe the chance of a loss.
Chance: the Webster Dictionary defines this word as 'something that happens unpredictably without discernible human intention or observable cause' In other words, risk in the financial context stands for the uncertainties associated with future cash flows.
We have learnt earlier how savings transform to 'Risk Capital'. We have taken a hard look at equity risks 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 the introduction 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 to make choices, are what the story of risk is all about. And that story helps define what it means to be a human being...'
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 three years.
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 gain 28% 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 in three 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 next two years means that his investment would be worth Rs1,30,560. Thanks to the 'power of compounding. 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.
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 this case. On the other hand, the government bond gives a fixed return with no question of a default.
What if the analyst got it all wrong? For all you know, a competitor might increase capacities and kill the market in the second year. Hence, the expected 28% appreciation might actually turn out to be a decline! 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 government bond.
Let us now add a twist to the second investment option and see if it makes a difference to Mr. Savvy Investor's choice.
The leading analyst expects the stock to go up by 12% this year as the company has finished expanding its capacity six months before time. He also expects the stock to gain 28% in the next two years.
Mr. Savvy Investor does his calculations to figure out that his investment, in this case, would fetch a return of 43.4% in three years. A good 13.4% more than the government bond.
Like earlier, the uncertainties still remain. However, since Mr. Savvy Investor earns 43.4%, he can still take the chance. If the stock fails to go up by 28% in the next two years and instead goes up by just 17%, he will still make a return of 31%! In other words, the higher return provides a margin of safety.
Hence, the higher rate of return over the government bond for the same period makes Mr. Savvy Investor prefer the second option of investing in the stock.
The extra return that the stock market or a stock must provide over the risk-free rate of return to compensate for the market risk is called "Equity Risk Premium".
In case of Mr. Savvy Investor, the extra return of 13.4% over the risk-free 30% rate of return on the government bond defines his "equity risk premium"
How do you determine 'equity risk premium'? What is the right premium to settle for? What is 'Beta'? More of this next time as we brace ourselves to risk the stock market and brave the uncertainties.
As one great statistician wrote, "Humanity did not take control of society out of the realm of Divine Providence...to put it at the mercy of the laws of chance."
Ideas that worked out for me which I would like to share with others
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