How to analyse risk in various riskless investment options

RISK is inherent in any investment. However, its meaning and implication on returns are rarely understood bymostretailinvestors.Termslike high risk, high gain, and no gain without risk have become too commonplace. These terms give an impression that if you take high risk, your gain is high too. If this were the case, everyone would take high riskandearnhighreturns.However, high risk may involve high losses too, which is often the case. On the other hand, very often, investors come across products marketed and sold as risk-free investment. Though these investments aremarketedasrisk-free–andthey can be called so technically – there is always an amount of risk inherent even in risk-free investment.

Risk in investment

Risk in any investment measures the degree of fluctuation in the returns. Higher the fluctuation, higher the risk. Risk also means the possibility to lose the invested capital. If this possibility is high, the investment is deemed as high risk.

The possibility of losing the investment varies with the fluctuationsinthereturns.Thisisthereason stocks are called high-risk investment, because the fortunes of investors may experience extreme swings as the markets fluctuate. On the other hand, bonds are considered risk-free because there is no fluctuation in the returns of bonds. The return is fixed, and hence, they are known as fixed-income securities.

Bonds are of two types – corporate bonds floated by companies and government bonds floated by government or its associated agencies. Corporate bonds are known as low-risk investment, bank deposits look more attractive compared to bonds. Hence, bond prices go down. The reverse happens in case of downward movements of interest rates. Lower interest rate makes bank deposits less attractive, raising the demand for bonds resulting in higher prices.

Inflation risk

RInflation is the biggest risk in bond investments. Inflation reduces the real return on investment. The interest rate mentioned in any bond is the nominal return. Accounting forinflationinthisreturngivesthe real return. A higher inflation rate means lower real return. In fact, if the inflation is more, the real return can turn negative.

Suppose you invest R1 lakh in a bond paying 8% returns. This means your investment of 1 lakh will turn into R1.08 lakh after a year. Now suppose the rate of inflation is 6%. This means the amount of goods and services R1 lakh used to buy will cost R1.06 lakh the next year. This means your real returns is not 8% but only 2%. If the inflation rate goes a little higher, the real return can go into the negative zone.

Despite these risks, risk-free investments are popular among big corporations, pension houses, and many government agencies that need to be conservative in their approach. This is still the best choice for the investors with very low risk appetite. The writer is is CEO, BankBazaar.com