InvestorQ : Can you explain what is meant by risk-adjusted asset allocation and what is the need for an investor do a risk-adjusted asset allocation using MFs, bonds, deposits?
Katherine Gonsalves made post

Can you explain what is meant by risk-adjusted asset allocation and what is the need for an investor do a risk-adjusted asset allocation using MFs, bonds, deposits?

Rutuja Nigam answered.
3 years ago

When an investor invested a chunk of his savings in the Fixed Deposits (FD) of an NBFC, he was thrilled as the NBFC FD was offering 1.5% above the market rate. He was pleased that he had locked his money in a high yielding FD with low risk. But he was in for a rude shock when the NBFC defaulted on its FDs after just 1 year resulting in the investor losing a chunk of his hard earned money.

Another investor was a firm believer in debt mutual funds as a safe and solid investment. She had recently put money in Bond funds which held government bonds of long tenure. A few months later, the RBI raised interest rates by a total of 1.5% over a period of 6 months due to sharply rising inflation. Since bond prices move inversely with interest rates, there was sharp fall in the NAVs of her bond funds. She panicked and booked out of the debt mutual funds at 8% loss although she could not understand why a debt fund invested in government securities could ever make a loss.

A veteran investor in Mumbai was comfortable investing in mutual funds of a certain AMC as they had consistently given good returns in the past. When they launched a New Fund Offering (NFO) with a pharma fund as the focus, he immediately jumped at the offer. Within 6 months, the fund NAV had depreciated by 22% forcing him to sell out as he had counted on the pharma fund to pay the margin for his apartment loan.

What is common between the above 3 investors. What they did was quite logical. However, the common thread between the above cases is about “Not understanding the risks involved”.

Why did each of these investors lose money in what was a good decision to begin with? The answer is that there is nothing like a risk-free investment. Any investment entails a certain degree of risk. In the above case of the first investor, he needs to appreciate the fact that an FD offering higher than market returns has to earn that much higher on its assets. Default risk (the risk that the issuer does not pay the interest and principal) is the most basic risk that investors need to be conscious of.

The case of the second lady is slightly more complicated. She had invested in a Government Bond Fund believing rightly that government bonds do not have any default risk. But then there is something called Interest rate risk. That is the risk that when interest rates go up, the value of your bond funds will go down. She had focused more on the default risk but did not anticipate that the RBI decision to raise interest rates could have such a huge impact on her investment.

Finally the case of the veteran who chose to stick to one AMC represents the basic premise (likely erroneous) that most investors follow that “Every product coming from a reputed fund house must outperform”. That sadly need not be the case. In this case the first risk was that it was a pharma fund so Shankar should never have relied on a pharma fund to meet future liabilities. Secondly, pharma stocks crumbled in the last one year due to factors like lower margins, problems with US FDA approvals, slowdown in emerging markets etc. These are factors outside the control of the fund house, however reputed it might be.

What is the answer? The solution; “Do a risk-adjusted allocation of your assets”

That is the right approach. To do a risk-adjusted allocation, you need to first understand the risks involved in your investment decision. Here is a quick check-list of how you can go about asking the right questions about a risk-adjusted allocation of assets. Go through each of these points in detail as there are some unique nuances in each of them.

· When you are buying equity funds, ensure that they are adequately diversified. Focused sector funds and mid caps entail a higher degree of risk. There is nothing wrong in them but as an investor you need to adjust for the higher risk entailed.

· When buying debt funds remember that the professional view on interest rates is a very important criterion. If the view is that interest rates are going up then it is better to stick to liquid or flexible funds with short tenures. On the contrary, if the view is that interest rates will go down then it is better to stick to long dated bond funds as they will give higher capital appreciation. Following this basis rule ensures that you are allocating assets after adjusting for risks.

· When buying assets like FDs and corporate bonds remember that these instruments are subject to default risk. Go by the credit rating, market standing and track record of the issuer rather than by the rates of return offered. After all, safety of your principle is a lot more paramount for you.

The key to risk-adjusted allocation is all about understanding the risk entailed in various investment products. There is nothing like a risk-free investment just like there is nothing like a free lunch. Once you understand these risks, you are in a better position to evaluate the actual returns on a risk-adjusted basis. In short, risk adjusted allocation is based on the premise that you first understand the risks (all types of risks), then you factor for these risks and finally you allocate to the assets that give the most optimal risk adjusted returns. That is the key.