VR Logo

Risk and volatility

I find it remarkable that even now, whenever the equity markets fall, there is a chorus of investors who lament the 'risky' nature of mutual funds

Risk and volatility

As you are reading this column, returns from debt funds are falling sharply.

Of course, this is a reaction to interest rates in the economy turning upwards. When interest rates rise, the value of older, lower interest bonds falls, leading to lower NAVs for debt funds. This effect is particularly sharp when this change is unanticipated or the reverse of what fund managers expect.

In a way, this is no different from what happens in equity funds, too. When a fund manager anticipates something, and the equity markets don't do that, then funds lose money. The difference is that in equity, there are a hundred different things to do. There are so many sectors and companies, and so many of them have their own dynamics and their own different value points. In sharp contrast, debt funds have very few variables, and interest rate movements tend to dominate all the other factors. If there are sharp surprises in interest rate movements, then the entire lot of debt funds rise and fall almost as one.

On the whole, from the point of view of the individual investor, one should not anticipate an impressive income from fixed income assets for the foreseeable future. In fact, ever since the Indian stock markets and equity mutual funds matured in the early 90s, there has never been a case for using fixed-income investments for long-term gains. However, I find it remarkable that even now, whenever the equity markets fall, there is a chorus of investors who lament the 'risky' nature of mutual funds. Earlier this month, just when the markets dropped in response to Donald Trump's trade-war threat, I got this on Twitter: "I have taken a vow to stay away from mutual funds, which are giving negative returns and are highly risky except for investments in debt funds..." I don't blame the writer because this is conventional wisdom in India. A decline, any decline, in the value of an investment is 'negative return' and risk.

As it happens, Warren Buffett has an answer to this in his annual letter to shareholders released just days ago. Here's what he says about a particular investing decision he took: Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date. "Risk" is the possibility that this objective won't be attained. By that standard, purportedly "risk-free" long-term bonds in 2012 were a far riskier investment than a long-term investment in common stocks. At that time, even a 1% annual rate of inflation between 2012 and 2017 would have decreased the purchasing power of the government bond. ...in any upcoming day, week or even year, stocks will be riskier - far riskier... As an investor's investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates.

Although his comment was about a particular investment in the US, the principle he explains is universal. On any given day, month or year, stocks are riskier. On the whole, over a period like five years or more, fixed income is far riskier. Only those investors who can face short-term volatility while staying confident about long-term prospects should invest in equities or equity-based investments. In India, this is particularly difficult because of the decades-old fixed-income investing culture that we have. There's no cure for this except understanding and experience.