There are thousands of mutual funds. They invest money in shares, debt (especially corporate debt), gold, real estate, foreign exchange, commodities, etc. You will agree that the prices of the assets in which mutual funds invest constantly change, moving up or down. Any investment in such assets is therefore subject to the investment risks of the basic asset. This is the basic reason that mutual funds carry a risk in investment. The NAV of mutual funds or the prices of shares move up or down, or do not move up as much as expected.

Apples must be compared with apples

When an investment carries a risk, a projected (expected) rate of return cannot be compared of another investment where the risk is lower. For example you expect that the rate of return that you will earn in Mutual Fund A is 20 % in one year. As opposed to that you also project that a bank fixed deposit will give you 7 % in one year. It is scientifically wrong to say that the mutual fund gives a higher return than the fixed deposit on the basis of this information. The fixed deposit is very low risk (especially if it is a nationalized bank), while the mutual fund carries a much higher risk. In order to compare the two, the return on the mutual fund should be adjusted to the risk it carries. As it is said in finance apples can be compared with apples, apples cannot be compared with oranges.

Meaning of Risk

When we say that an investment carries a risk, we are in effect indicating that you may earn more than the projected rate or you may earn less than the projected rate. In other words, the returns will fluctuate – sometimes more, sometimes less, sometimes not as expected. The more the fluctuation of the market price, the more the risk and vice versa. The expectation of higher return is because of the fluctuation. The investor hopes that he can buy when the price is low and sell when the price is high and thereby get a high return. Let us take an example to understand this point.

Suppose I buy a share when the price is Rs. 150. The share price in the next year fluctuates between Rs.75 and Rs.230. My hope is that I will sell it at Rs.230 and make Rs. 80 profit, i.e. 53 %. When the price touches Rs.230, I do not know whether it will not go beyond Rs.230 or fall down. I hold on to the share, and not sell it, in the hope that it will go up further. Within a few days the share falls down to Rs.150. Again I hope that the share price will again go up. Actually it falls to Rs. 140 and I panic and sell thinking it is better to cut down on loss rather than hope for a profit.

Investors are faced, in a practical sense with such investment decisions. This is one of the ways in which risk works out for investors in a practical sense. In a investment decision the timing of the purchase or sale is more important than the duration you hold the risky asset. If you get the timing right you make a profit or else you end up in a loss. The legendary investor Warren Buffet once said that if he is right in 50 % of his investment decisions, he considers himself lucky!

To calculate investment risk, the spread of the lowest and highest prices (Rs. 80 and Rs. 230 in the example above) and the frequency of the fluctuations (i.e. how often does the price go up or down) are taken into consideration and statistically the standard deviation is calculated. The higher the fluctuation and more the frequency of price movement (called volatility in finance); the higher the standard deviation. The higher the standard deviation; the higher the risk and the lower the standard deviation the lower the risk.

For example the bonus rate on Table 14 of LIC for the past 10 years has been Rs. 42 per thousand sum assured for terms less than 20 years and Rs. 48 for terms more than 20 years. The standard deviation on this will be zero. The meaning of this is that there is no fluctuation of the bonus in the long run and by extension there will be no frequency (number of times) of change in the bonus rate. Hence we say the risk is low.

Comparison of the performance of Table 14 with that of a mutual fund cannot be done in a direct manner. There are statistical methods to do so.

The Methods of Comparison

There are available methods to adjust the risk of higher risk investments to make them comparable with each other and with the lower risk investments. The more popular methods are the Sharpe Method, the Linter Method, etc. (See www.investopedia.com for learning more about such methods). Here we shall try to explain in very simple terms how this is done.

Scientists like Sharpe, Linter, etc. have developed formulas by which the expected return on a risky investment is adjusted to the risk so identified. The methods employ the laws of probability. In a very simple manner we can say for example, that if the expected return on a mutual fund is 15 %, and if the probability of earning 15 % is 40 %, then the risk adjusted rate of return is 40 % of 15 % = 6 %. The Risk Adjusted Rate of Return (RARR) can now be compared to lower risk investments. The RARR allows us to correctly compare apples with apples and we will be scientifically right.

So if the projected return is 15 % on a mutual fund and the risk adjusted rate on the same mutual fund is 6%; and if the bank is giving 7 % interest, the bank is probably better than the mutual fund! If the calculations are made you will find that Table 14 gives better returns than most of mutual funds in the market. This will be the subject of a future blog post to help you to Help India Insure.

Help India Insure – educate your customers on Risk Adjusted Rate of Return.