Finance and Economics Education for the Life Insurance Sales and Marketing Persons
Knowledge is Power
Learn Concepts that Are Today’s Market Language
This is the first article of the Explained Series of Articles from me. In this series I will be explaining a few concepts in financial theory and how they are linked to selling life insurance. It is important to know these financial concepts to understand the financial markets and also to know how to canvas for life insurance products.
What is Risk?
We often hear the term “risk” in investments. A simple understanding of the term risk is:
The chance of getting back the principal we have invested and/or the chance of earning the expected interest/dividend on an investment.
If you invest Rs.100 in shares or mutual funds and Rs. 100 in traditional life insurance endowment or banks, which investment is safer? You know the answer isn’t it? Without knowing the theory on risk and investment you can understand which investment is risky and which is not. For any individual investing money, this understanding is more than enough. A simple, working idea of risk is all that is needed for individual investment decisions. Financial advisors however complicate things for their own purposes. In their sophistication of finance and investment decision making, they make it seem that only they know the subject of risk and how to measure it. The fact is that scientists and researchers on the subject of risk are struggling to understand what risk is and how it is to be measured. We will come to this aspect of the theory of risk in a later article.
For now we are concerned with a very basic understanding of risk and return, since the language of the customer now includes the language of finance. However it must be mentioned at the outset that financial experts do not agree on one definition of risk or on any one method of calculating the degree of risk.
A Popular Method of Knowing the Risk in an Investment
One of the most common methods of measuring risk is to measure the volatility of returns. Stated in the language of financial management, risk is the volatility of future returns on an investment.
Suppose you invest in a bank deposit for 5 years, and the bank promises you an interest rate of 7 % for the next 5 years. No matter what happens in future the bank will give you 7 % every year for the next 5 years.
In risky investments the situation is different. Future returns are not steady every year. Future returns fluctuate from year to year, from one time period to another. On some investments the returns fluctuate more than they do on others. Take a look at the chart below to understand this point.
Volatility of Returns
I am unable to show the chart on this page, due to my limited understanding of designing this page. You can however download the chart and save it to view it, by clicking on the link below
In the Chart the returns are mentioned on the Y-axis and the time period on the X-axis.
- The chart shows that the returns on Share A have fluctuated between a low of 1 % in the sixth year to a high of 5 % in year 1. The range is 4 % between the highest rate and the lowest rate for Share A.
- That of Share B has fluctuated between a low of 2.5 % and a high of 15 %. The range of fluctuation of Share B is 12.5 %.
- The return on Share C has fluctuated between a low of 10 % and a high of 28 %. The range of fluctuation of Share C is 18 %.
- From the chart we can also see that the fluctuation on a year-to-year basis is particularly volatile, (very wide fluctuation) for all shares except for Share A during the period 3rd year to 5th
More the volatility of returns, more the risk in the investment.
Low risk investments are less volatile
Typically for a low risk investment there is very little or no volatility. Take for instance Table 14 of LIC for more than 10 years the bonus for terms greater than 20 years it has been Rs. 48 per Rs. 1000 sum assured. On the graph above it will be a straight line. Less volatility means less risk.
Implications of volatility on actual returns for the investor
The steady returns year after year is a huge plus point for traditional life insurance products, as far as investing is concerned. A steady return year after year, in the long run very often results in more profits to the investor when compared to an investment that gives volatile returns. Read my article “And the Tortoise Wins” in this blog on how this happens.
How is risk measured?
The next step is to understand how risk is measured. The fact is that there is no agreement on how risk can be measured. In practice, there are many ways in which risk is measured. There are however no fool-proof methods of measuring risks. Very often risk measured by one method can give you diametrically opposite results as compared to another method. It is believed that there are more than 200 methods of calculating risk. In practice however financial analysts need to measure risk in order to take their investment decisions. The more popular methods are the Sharpe Ratio and the Treynor Ratio.
At the heart of risk measurement is use of the statistical tool of standard deviation. To project the future rates of return on a risky investment the probability of the predicted rates actually occurring in future.
For our limited purpose however we do not have to go into all this statistical knowledge. This is the sophistication that financial advisors want their customers to go into. When the experts – those that study the science of risk assessment and prediction – themselves do not know, why should a layman customer even bother about the sophistication? It is sufficient for individuals making their investment decisions to know that a particular investment like shares is more risky than an investment in a traditional endowment policy. Or that mutual funds are more risky than post office savings.
How is risk related to return?
Risk and Return are two sides of the same coin. If we state the risk in an investment it is as good as stating the return. Both risk and return are projected; they are only indicative and not definitive. No one can project the future with certainty.
If the expected return on an investment is high, invariably it means that the investment is of a high risk. So if a nationalised bank gives say 7 % on its fixed deposit and a cooperative bank gives 8 %, it means that the cooperative bank is more risky. If on a mutual fund we expect 15 %, it means that the mutual fund is even more risky.
The principle to understand is that:
More the risk in an investment product, more the expected returns.
BUT
Returns Are Uncertain Risks Are Certain
Expected returns are not guaranteed returns, it is only a hope, an expectation that may or may not happen. As they say in the world of finance, money does not grow on trees. You stand a chance (not a guarantee) of getting higher returns only if you are prepared to take higher risks. But if you take the higher risks you also stand a chance of not getting the higher projected returns. This is referred to as the probability of the future expectation occurring. This is risk of investing in higher risk investments.
A practical implication of this understanding is that while it is possible that one can get higher returns by investing in risky investments, not all investors succeed in actually getting the higher returns. Further the same investor will not be getting higher returns every time he or she invests in high risk investments. This is the meaning of risk in investments in a practical sense.
We can see this in actual returns on mutual funds. The financial analysts claim astounding returns on mutual funds by quoting the example of only those mutual funds that gave high returns in a particular period in the past. This is not to be disputed. That a particular fund gave higher return in the past may be true. Some funds may give high returns in a particular year. But the more important truth is that the same mutual funds as a rule do not give the same high returns year after year. The NAVs are subject to fluctuations (volatility). If we take all the mutual funds that are on offer in the market, about 55 % of the mutual funds earn a risk adjusted rate of return of 8 % or less at any given moment in time. The returns on lower risk investments are also in the same range. Why should you invest in mutual funds with all its risks for more or less the same rate of return as low risk investments? Read my article (Bull Run or Bear: It is Never Safe to Invest in Mutual Funds ) in this blog for the actual statistics.
About 90 % of all money invested by Indians is in low risk investments (Read Where do Indians Save?). What this data tells us is that when you meet a customer he is more inclined to low risk investments rather than high risk investments. This is the real fact of Indian attitudes to saving and investment.
Suppose you tell customers that there is a 50-50 chance of getting say 15 % return on an investment, most customers will not invest their money. If you tell customers that there is a 95 % chance of not earning 15 %, almost all customers will walk out of the investment. But if you tell a customer that there is near 100 % chance of getting 7 % in a bank deposit or in a traditional endowment product, almost everyone will invest. Change your selling language to risks and move away from returns.
The mutual fund adviser discusses returns, because he or she cannot discuss risks. A life insurance adviser is uniquely placed to discuss risks. The life risk and the investment risk. This is our strength.
If you discuss risks with customers they will build better trust and confidence in you.
Sell risks not returns
Returns are UNCERTAIN Risks are CERTAIN
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