Rajen Gala

We sometimes hear of a commonly used financial term called “Beta”. But what is it? Beta (β) is a measure of the volatility of a security or portfolio or an individual Mutual fund compared to the market as whole. Beta describes the relationship between systematic risk and expected returns on assets. Let me explain…. When making an investment, it is necessary to check the fund returns but that alone is not a sufficient condition. Evaluating other parameters like “beta” helps in making better investment decisions in keeping with one’s risk profile. You can think of beta as the tendency of a security\’s returns to respond to swings in the market. If a mutual fund has a beta of 1.0, it indicates that its price activity is strongly correlated with the market benchmark. A fund with a beta of 1.0 has systematic risk. However, the beta calculation can’t detect any unsystematic risk. Adding a stock to a fund with a beta of 1.0 doesn’t add any risk to the fund, but it also doesn’t increase the likelihood that the portfolio will provide an excess return. A beta value that is less than 1.0 means that the fund is theoretically less volatile than the market benchmark. Including stock having beta less than 1.0 in a fund makes it less risky than the same fund without the stock. A beta that is greater than 1.0 indicates that the fund price is theoretically more volatile than the market benchmark. For example, if a fund’s beta is 1.3, it is assumed to be 30% more volatile than the market benchmark. Small cap stocks tend to have higher beta’s than the market benchmark. This indicates that adding the stock to a fund will increase the fund’s risk, but may also increase its expected return. If a scheme outperformed its benchmark you should try to understand, whether the beta of the scheme was high or the fund manager was able to deliver superior risk adjusted returns. Let’s demonstrate this with an example. Say there’s a housewife Suman. Her son is a complete brat. Perhaps he is the naughtiest boy not only in the building where they live, but also in his boarding school where he stays. Now suppose, Suman’s neighbour Seema has to attend to an emergency. Even Seema’s son is quite a brat and therefore most families in the neighborhood refuse to baby sit him. However, Suman willingly agrees because her own son is much naughtier than Seema’s son. So as compared to managing her own son, she finds it extremely easy to look after Seema’s son. This example shows that certain decisions are taken by using comparison as a tool. A fund with a low beta will better protect investors during downturns, but they will miss out on some gains during bull markets. Ultimately, an investor is using beta to try to gauge how much risk a stock is adding to a fund. While a stock that deviates very little from the market doesn’t add a lot of risk to a fund, it also doesn’t increase the potential for greater returns. Hence, while taking an investment decision, it becomes important to understand the expected volatility of your fund with respect to the benchmark and not just the performance.

How many millionaires do you know who have become wealthy by investing in bank savings account? You may have heard that investing in stocks can be a great way to create wealth over time, and it\’s certainly true. The stock market is made up of exchanges, like the SENSEX and the NIFTY. Stocks are listed on a specific exchange, which brings buyers and sellers together and acts as a market for the shares of those stocks. Stock prices on exchanges are governed by supply and demand, it’s very simple. At any given time, there\’s a minimum price someone is willing to pay for certain stock and a maximum price someone else is willing to sell for shares of the stock for. Since both investors cannot be correct, it is an adversarial system. In short, one investor will make profit and the other will suffer loss. Therefore, it’s important to become well versed on the investment you are considering. Let us look at SENSEX, how it performed in long term.   SENSEX Year Ending Sensex Closing Points Rolling 1 Year Growth Rolling 3 Years Growth Rolling 5 Years Growth Rolling 10 Years Growth Rolling 15 Years Growth Rolling 20 Years Growth Mar-79 100 Mar-80 129 29% Mar-81 173 34% Mar-82 218 26% 30% Mar-83 212 -3% 18% Mar-84 245 16% 12% 20% Mar-85 354 44% 18% 22% Mar-86 574 62% 39% 27% Mar-87 510 -11% 28% 19% Mar-88 398 -22% 4% 13% Mar-89 714 79% 8% 24% 22% Mar-90 781 9% 15% 17% 20% Mar-91 1168 50% 43% 15% 21% Mar-92 4285 267% 82% 53% 35% Mar-93 2281 -47% 43% 42% 27% Mar-94 3779 66% 48% 40% 31% 27% Mar-95 3261 -14% -9% 33% 25% 24% Mar-96 3367 3% 14% 24% 19% 22% Mar-97 3361 0% -4% -5% 21% 20% Mar-98 3893 16% 6% 11% 26% 21%   Mar-99 3740 -4% 4% 0% 18% 20% 20% Mar-00 5001 34% 14% 9% 20% 19% 20% Mar-01 3604 -28% -3% 1% 12% 13% 16% Mar-02 3469 -4% -2% 1% -2% 14% 15% Mar-03 3049 -12% -15% -5% 3% 15% 14% Mar-04 5591 83% 16% 8% 4% 15% 17% Mar-05 6493 16% 23% 5% 7% 15% 16% Mar-06 11280 74% 55% 26% 13% 16% 16% Mar-07 13072 16% 33% 30% 15% 8% 18% Mar-08 15644 20% 34% 39% 15% 14% 20% Mar-09 9709 -38% -5% 12% 10% 6% 14% Mar-10 17528 81% 10% 22% 13% 12% 17% Mar-11 19445 11% 8% 12% 18% 12% 15% Mar-12 17404 -10% 21% 6% 18% 12% 7% Mar-13 18836 8% 2% 4% 20% 11% 11% Mar-14 22386 19% 5% 18% 15% 13% 9% Mar-15 27957 25% 17% 10% 16% 12% 11% Mar-16 25342 -9% 10% 5% 8% 14% 11% Mar-17 29621 17% 10% 11% 9% 15% 11% Mar-18 32969 11% 6% 12% 8% 17% 11% Mar-19 38673 17% 15% 12% 15% 14% 12% Mar-20 29468 -24% 0% 1% 5% 11% 9% Mar-21 49509 68% 15% 14% 10% 10% 14% Probability of Gain 28/42 33/40 35/38 32/33 28/28 23/23 Markets are volatile in the short term. As the investor horizon increases the probability of loss reduces. E.g., the above table shows that, in the last 41 years of SENSEX, the likelihood of losing money for periods of 15 years or more has been NIL. From March, 1979 to March, 2021 markets have given a CAGR of 16.34%. Equity returns have been more than the normal GDP. SENSEX has compounded wealth at 16.34% over the long run. At this rate, an investment in the stock market has historically doubled approximately every 4.58 years.

All investments carry some amount of risk. It varies for investor to investor. It depends on age, income, fixed expenses, the number of dependents in the family, net worth etc. We often hear that people should invest in assets depending upon their risk-taking ability. But what is one’s risk-taking ability? or how much risk one can take? Or even one’s risk remains the same till the goal is achieved? There are many questions to be answered. Risk taking ability should purely depend upon one’s goals & one’s current financial condition. One must classify goals into short term, medium term and long term to arrive at a risk. Making a right investment choice is never easy. If the goals are short term, it is better to invest in fixed income. If the goals were for medium and long term, a certain amount of risk would be taken in order to improve return on investments. Risk taking abilities will also depend on the age factor. Younger & middle age investor can take more risk compared to old age investor. The problem arises when people tend to lose focus of their goals, they start investing to gain immediate returns. This changes the risk-taking ability drastically & the entire planning fails. So, deciding what amount of risk can be taken while remaining comfortable with investments is very important. A common misconception is that higher risk is equal to greater return. There can be a possibility to get higher returns but there cannot be any guarantee. Risk taking abilities plays most important role to achieve the goals in a disciplined manner for which the particular investment is to be done.

Do you know the difference between Nominal Rate of Return & Real Rate of Return? Interest rates can be expressed in two ways, as nominal rates or real rates. The difference is that nominal rates are not adjusted for inflation, while real rates are adjusted. As a result, nominal rates are almost always higher, except during those rare periods when deflation, or negative inflation, takes hold. Real rate of return is the annual percentage of profit earned on an investment, adjusted for inflation. Therefore, the real rate of return accurately indicates the actual purchasing power of a given amount of money over time. The real rate of return is calculated by subtracting the inflation rate from the nominal interest rate. The formula is: Real rate of return = Nominal interest rate − Inflation rate Example: Assume a Fixed Deposit pays an interest rate of 6% per annum. If the inflation rate is currently 4% per annum, the real return on your savings is only 2%. The general rule in economics is that the value of money today will not be equal to the same amount of money in the future. Also known as the time value of money, this is a central concept in finance theory, which takes into account factors such as inflation. Other Factors Affecting Real Rate of Return The problem with real rate of return is that you don\’t know what it is until it has already happened. That is, inflation for any given period is a \”trailing indicator\” that can only be calculated after the relevant period has ended. In addition, the real rate of return figure isn\’t entirely accurate until it also accounts for other costs, such as taxes and investing fees.

Human Brain is divided in to three major sections Outer Layer Middle Layer Inner Layer Outer layer of the brain is known as the Rational Center, which handles complicated cognitive processes, such as objective thinking & rational decision making. It is also known as cerebral cortex. The cortex is the brain\’s logistical centre. It is the director of executive function & motor control. The part of the cortex called the prefrontal cortex is most interest to this discussion. The prefrontal cortex is involved in abstract thinking, planning, calculation, learning, & strategic decision making. Middle layer is considered to be emotional centre. It is also known as limbic system. The brain\’s limbic system is the emotional driver of the brain. Within the limbic system is the amygdala, which processes the emotions, translates outside situation in to specific emotions such as fear or excitement. Inner layer is knows as Habit Center. Habit centre processes everything we do automatically without thinking. It includes not only habits but also basic body functions such as breathing, circulation, movement & sensations. The most significant anatomical part of the habit centre related to financial decision making involves the basal ganglia, which automatically seek out anything we recognize as rewarding, thus leading to the formation of habits. These three parts of the brain Rational Centre, Emotional Centre & Habit Centre work to getter. They are connected to each other by neural circuits, i.e. pathways that use special chemicals to send information back & forth among different part of the brain. Let us consider an example. If you have gone long in the stock Market with huge investments and suddenly you get a message that there is a big scam. Within 10 to 12 milliseconds what you heard, activities part of your brain, that processes emotions & you feel frightened & anxious, your emotional brain immediately sends a chemical message to your inner brain, your heart will start beating faster & your breathing to become shallower, you try to figure out whether stock markets has slide and suddenly some other bad news flash on television related to stock markets. In the case the layoff rumor, for instance, our anxiety & fear blocked our ability to make a rational decision to check out the accuracy of the rumor. The danger system is the circuitry in the brain that gets activated when we feel threats to our survival. You decide that the rumor is probably true so your anxiety level rises & your heart rate continues to beat rapidly all of this has happened in a matter of seconds you start to panic. Market has slide and you have sold all your stocks, and further you have gone short in the stock market. Now you are sure that the markets will slide further. But suddenly stock market rises without any reason. And now when you had gone short you have to square up your position. You incur a huge loss. Most financial phenomena are not governed by predictable patterns. Stock market goes up – we think it will keep going up. Real Estate market is hot – we assume it will continue. We have gotten a rise in our income every year – we expect to see increase next year. There is no reason to believe that something will keep happening just because it has been happening. In fact if the past is the predictor of the future, then what it really tells us is that what goes up must come down & vice versa (Neutrons Law). As hersch shefrin says \”Past performance is a great predictor of future expectations, not future performance\” Most investors avoid financial risk after a recent loss, to their financial detriment. Risk avoidance is pretty smart after most type of losses -that\’s how we learn from mistakes & try to avoid unhealthy risk. Emotions are subjective feelings that serve as easy shortcuts for the brain. On the one hand, the emotion of excitement indicated that one had identified an opportunity. Excitement propels increased risk seeking & exploratory behavior. On the other hand, the emotion of fear notifies one of the potential dangers. Fear gives rise to behaviors of risk aversion and withdrawal. Emotions are like a traffic light for the brain. When considering an opportunity or threat, emotions indicate whether one should go forward with risk taking (excitement), proceed with caution (concern), or stop withdrawal (fear). Such emotions are anticipatory. They help people broadly prepare for threats or opportunities and they are fundamental to the coordination of thought and action away from danger (loss avoidance) or towards opportunity (reward seeking). As a further example, among many investors fear leads to knee jerk expectations of an impending recession or price decline, and it often drives premature selling of risky holdings. Yet if you ask a fearful investor why they are selling, they usually won’t say “because I’m afraid”, rather, they might cite negative economic events.  Emotional investors are unaware that it is not facts that are driving their outlook, but perceptual distortions caused by feelings.

You may wonder – \”Do I really need a financial plan?\” Some feel that saving regularly in bank recurring deposits or Systematic Investment Plans (SIPs) in mutual funds is financial planning. But allocating savings and investments in ad hoc manner is not enough to achieve your life goals.  And such investments lead to inefficient utilization of your financial resources. What is Financial Planning? Financial Planning is the process of meeting your life goals through the proper management of your finance. Financial Planning provides direction and meaning to your financial decision. The main elements of a financial plan include a retirement strategy, a risk management plan, a long-term investment plan, a tax reduction strategy, and an estate plan. A financial plan is a document containing a person\’s current money situation and long-term monetary goals, as well as strategies to achieve those goal. A financial plan may be created independently or with the help of a Certified Financial Planner. The plan should not only be comprehensive, but also highly individualized to reflect the individual\’s personal and family situation, risk tolerance, and future expectations. The plan starts with a calculation of the person\’s current net worth. You cannot create a financial plan without cash flow. You must know where your money is going every month. Cash flow will help you see how much you need every month for necessities, how much might be left for saving and investing, and even where you can cut back a little or a lot. Calculate how much you\’ve paid over a year in basic housing expenses like rent or mortgage payments, utilities, credit card interest, and even home furnishings. Add categories for food, clothing, transportation, medical insurance, and non-covered medical expenses. Document your real spending on entertainment, dining out, and vacation travel. Even look for cash withdrawals that may be used for sundry expenses. Look on your personal spending. Once you add up all these numbers for a year and then divide by 12, you\’ll know exactly what your cash flow has been. Consider your goal priorities. They may include funding education for your children, marriage of your children, buying your dream home, retire on time, or leaving a legacy, etc. No matter what your priorities are, the plan should include a strategy for accumulating the retirement income you need. Asset Allocation plays most important role in financial planning to achieve all your goals. Your destination is important. However, the journey matters too. None of us is 100% rational. We are emotional beings. Even though we might be very optimistic about equity or mutual fund returns, sharp losses worry us. Remember, nothing is guaranteed with equity or mutual fund investments. Be honest about your risk appetite. During good times, everybody claims or wants to be an aggressive investor. It is during bad times that the true risk profile of an investor can be assessed. Don’t worry if you got it wrong the first time. Learn from these losses and adjust your asset allocation to achieve your life goals.

Risk management aims to control the damages and financial consequences of threatening events. Life is full of uncertainties. A person, who is happy, healthy and alive today, does not know what will happen tomorrow. Uncertainties translate into risks. How can Risk be managed? While risks cannot be eliminated, measures can be taken to reduce the probability and size of loss caused by risks. This process is known as risk management. A) Risk Control:  Risk Control is the method that seeks to reduce or minimise the risk of loss. It consists of risk avoidance and risk reduction. Risk Avoidance is the elimination of hazards, activities and exposures that can negatively affect, in simple words it means not performing any activity that may carry risk. Example: Parents are worried that their children may get injured as a result of cycling on the road; they can avoid the risk by ensuring that their children do not cycle on the road. Risk Reduction is a risk management technique that involves reducing the consequences of a loss. This encompasses a whole range of things including reducing the severity of a loss, reducing its frequency, or making it less likely to occur overall. Example: Parents find that it is not possible to prevent their children from cycling on the road in view of their obstinacy; they can impose a rule that their children wear helmets and safety pads when cycling. This will reduce the chances of their children being injured. B) Risk Financing: Risk financing is a technique where the loss arising from the risk is absorbed or transferred to someone. There are two ways of risk financing i.e. risk retention & risk transfer. Risk Retention is the practice of setting up a self-insurance reserve fund to pay for losses as they occur, rather than shifting the risk to an insurer or using hedging instruments. Example: The risk of suffering from common cold can be retained. As a general rule, risks that should be retained are those that lead to relatively small certain losses. Risk Transfer can be defined as a mechanism of risk management that involves the transfer of future risks from one person to another, and one of the most common examples of risk management is purchasing insurance where the risk of an individual or a company is transferred to a third party i.e. Insurance company. Appropriate Risk Management Strategy Frequency of Event Severity of Financial Loss Risk Management Low High Risk Transfer High High Risk Avoidance Low Low Risk Retention High Low Risk Reduction