Learn to put up with Systematic Risk!

Learn to put up with Systematic Risk!

A N ShanbhagUpdated: Friday, May 31, 2019, 10:54 PM IST
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The events that have transpired over the last couple of weeks served as a strong reminder of the inherent risky nature of the markets to investors who otherwise may have been becoming slightly overconfident of the stock market. However, just as it is very easy to be overcome by greed and ignore the risk involved during a bull run, it is equally easy to be overcome by panic and sell lock stock and barrel during a fall in the indices. So we thought it was a good time to revisit the topic of risk – though we have dwelt on this subject before, the rapid fall in the indices warrants a reiteration. So basically the question is – what is risk and how does an investor tackle it?

Systematic Risk

Systematic Risk, as the name suggests is the risk inherent in the economic system. Macro factors such as domestic as well as international policies, employment rate, the rate and momentum of inflation and general level of consumer confidence etc. are what constitute systematic risk. Generally, investors cannot hedge or diversify against this risk as it affects all kinds of asset classes and affects the entire economy as such.

Unsystematic Risk

This is the risk inherent in a particular asset class. The best way to combat this risk is by diversification. However, one must remember that the diversification must be in the class of asset and not the asset itself. An example of the above is evenly distributing your portfolio in bank deposits, RBI bonds, real estate and equities. That way if a certain unsystematic risk affects let’s say the real estate market (say the prices crashes), then the presence of other classes of assets in your portfolio saves you from a total washout. However, note that diversifying within the same asset class (buying different equity shares) is not strictly combating unsystematic risk.

Interest Rate Risk

Interest rates and prices of fixed income instruments share an inverse relationship. Interest rates in the economy may fluctuate due to several factors such as a change in the RBI’s monetary policy, CRR requirements, forex reserves, the level of the fiscal deficit and the consequent inflation outlook etc. Extraneous factors such as energy price fluctuations, commodity demand and supply and even capital flows may result in rates fluctuating.

Then there are the event based factors that affect interest rates. For example, the 11/9 episode in the USA or the 26/11 in India. If terrorism increases or there is a war, interest rates will rise. However, typically such events are temporary in nature and in fact a good fund manager can actually take advantage of such hiccups.

Credit Risk

This is the risk of default. What if the company whose FD you invested in goes bankrupt? There have already been several such cases. Deposits with plantation companies and time share resorts are more cases in point. True, you have legal remedy…but everyone knows how much time our courts take.  The only factor which dilutes this risk somewhat is the credit rating. Investing in a highly rated instrument is safe but not sufficient.

Elimination of Risks

There is some good news though. Credit risk can be simply eliminated by investing in sovereign securities — securities issued by the government. There is simply no risk of default. Or so we hope! For retail investors, MFs offer gilt schemes where almost the entire corpus is invested in sovereign securities thereby achieving the same result. Investments such as PPF, Relief Bonds etc. are normally held till maturity. These are examples where both the risks inherent in debt instruments are at a bare minimum.

stock market

Currently what investors are facing is what we have described above as Systematic Risk. It is the risk inherent in the system and that which cannot be eliminated. To put it more specifically, the entire turmoil is essentially on account of China devaluing its currency to make its exports more competitive (cheaper). It is felt that in order to keep up, other countries will have to cut prices of their domestic manufacturing thereby spiraling a cycle of lower prices.

On our part, we cannot help but feel that the situation is being over-hyped and the markets have over reacted. In any case, India is not directly affected by these events and when the international investors discover the over-reaction (as it were), they will reenter the market stronger than before. In the meanwhile, we as domestic investors will have to hold still and hold out. Or to put it in other words, learn to put up with Systematic Risk!

(The authors may be contacted at wonderlandconsultants@yahoo.com)

A N Shanbhag

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