Debt and real estate are considered safe though.
There is always some risk involved in any method of deploying cash. Even if you stash it under the bed, you could lose it in a fire, or robbery. How you assess the risks associated with alternative deployments is partly subjective. Risk tolerance is definitely an individual trait.
Financial planners present simple strategies and neat risk: reward matrices for asset management. Figure out risk tolerance. Set return targets and timeframes. Find an asset allocation mix that reaches the targeted return without exceeding the risk tolerance. If there’s a mismatch between risk-tolerance and targeted returns, review and adjust the factors.
In reality, these cut-and-dried methods run into psychological barriers. Risk tolerance and risk perception are fuzzy traits. Even highly-evolved investors are often less than self-aware about their own risk profiles. Many people also have flawed risk perceptions.
Risk perception involves assigning a value and probability to specific risks. This is often done comparatively, than numerically. For example, the investor may perceive that long-term debt is more risky than short-term, and debt is safer than equity, among others.
Sophisticated investors often grapple with assessing the probabilities of inflation trends, or tax-policy changes, for instance. When the risk perception is flawed, an investor who is actually exposed to high-risks, may believe he has a conservative low risk-tolerance profile. Or vice-versa.
Risk perceptions can vary between individuals even when assessing the same risk. Say, two individuals consider buying the same share. Both know the share price may fall.
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But one thinks that is low-probability, another thinks it’s high probability.
One typical case of flawed risk perception is that of buyers in real-estate and precious metals. Both assets are widely perceived as low risk. In reality, both are volatile. Most of Wall Street went bankrupt due to flawed risk perceptions about subprime — the financial models assumed US real estate values could never go South.
Risk perceptions can also change and not necessarily in logical fashion. Right now, many people consider the stock market risky because its been falling for six months. But if it spurts up 20 per cent in the next three months, the same people will consider stocks less risky — even though there be greater potential downside.
Two related but different questions may help to clarify the difference between risk-tolerance and risk-perception. First: Do you consider the stock market very risky, somewhat risky, or not so risky? The answer is related to your risk perception with respect to the stock market. Now, suppose you are told that the stock market is somewhat risky, and then asked if you are prepared to invest in stocks. This answer will be related to your risk tolerance.
It is often difficult to change risk perception through logic. One can cite pages of historical data and statistics to assert that the stock market is not very risky for an investor with a long timeframe. Nevertheless, stocks will be perceived as risky by somebody who has previously been burnt buying dud equities.
The comparative risk-reward equations of three major asset classes is unusual in India. In most economies, debt, real estate and equity are ranked in ascending order of risk and reward. I am not sure this is entirely true for India.
Indian debt carries a lot of risk. There is no secondary market offering liquidity. There is no legal recourse in a default (or rather, legal recourse may take decades). Inflation is under-stated. Safe instruments like T-Bills and bank fixed deposits offer negative real returns.
Real estate is so localised and opaque it is difficult to assess what the risk:reward ratios are. Most rental yields are low. If you sell a given property, park the after-tax capital in fixed deposits, and rent the same property, there will be a big surplus in your favour. The black component of real estate transactions also makes it tough to assess capital appreciation. The chances of litigation and interminable lawsuits is high. You can make huge returns. You can also get stuck for years in sub-par situations.
In contrast, the risks for equity are visible upfront. So are returns. Transactions are transparent and instantaneous. Equity does yield a substantial premium over debt and it does give real returns that beat inflation.
The clincher is that equity offers excellent exposure to debt and real estate, due to the many listed stocks from those sectors. Whenever the financial sector or real estate has boomed, capital appreciation in financial stocks and realty stocks has been even higher than the returns from actually buying real estate, or investing in debt.