What does risk mean?

It varies across investors as per their risk profile. And so will the method to determine a risk-free benchmark.

If an asset is risky, it must offer extra returns. Indeed, long-term returns from risky assets like equity, commodities and real estate, generally, beat returns from safer assets like debt. What sort of risk is involved in exposure to any given risky asset? How much excess return might it generate?

In profiling the risk:return, problems can arise in just defining the risk and finding a mathematical proxy for it. Many popular ratios are used to calculate risk-adjusted returns, which points to the fact that risk means different things to different people. A logical definition of risk is just the first step. Even domain experts like rating agencies can make a complete hash of actually judging risk.

Risk-return profiling also involves defining a risk-free benchmark return. This can also vary. A conservative investor may consider government debt securities. A hedge fund or active mutual fund might use the return of a stock market index as its “risk free” benchmark.

Another approach is to benchmark to a preset minimum acceptable return instead of a risk-free return. This may be set on the basis of the cost of funds, for a leveraged portfolio. In the broadest terms, any real return must beat inflation. So beating inflation could be a minimum acceptable return for conservative investors.

The commonest way of calculating risk, is to use the standard deviation of returns as a proxy for volatility. Some use “negative deviation” - that is, the standard deviation of only the negative returns. The logic is that nobody minds volatile but positive returns.

If we view the Indian financial landscape with the goal of beating inflation as the minimum acceptable return, the understanding of risk and asset allocation changes. Inflation is itself volatile. Second, inflation data is suspect because the data-gathering mechanisms are inefficient. Third, the wholesale price inflation (WPI) is commonly used and WPI doesn't accurately reflect inflation at consumer level, which is key to individuals.

The RBI targets holding WPI at five per cent. If it did achieve five per cent, the implication would be that the value of money would halve roughly every 14 years. In fact, the RBI often fails to achieve its inflation target. For the past year, inflation has been closer to ten per cent and that rate would halve the value of money in 7 years.

There is a problem in beating inflation using only passive exposure to risk-free debt. It cannot be done in India where inflation often outruns debt yields. For example, bank fixed deposit rates have been between 100-250 basis points lower than inflation for the past 10-12 months. This situations often occurs - banks try to keep their net interest margins as high as possible.

This means that there are long periods of time when debt returns are lower than prevailing inflation. Hence, the value of money erodes if it's kept passively in “safe” debt, although the principal may remain safe.

Beating inflation therefore, involves taking on some risk of capital loss. A conservative investor must weigh up the likely risk of under-performing inflation by staying overweight in debt. Then he should compare those risks to the potential capital loss from risky assets.

This is a complex task. It requires estimation of the future behaviour of several volatile variables. For example, if the expectation is that inflation will be around 10 per cent for a given period, the investor should try to find assets that return 11 per cent or more.

The safest way to try and beat inflation is to mix assets with a varied risk-return profile. For example, the conservative investor might hold a combination of debt funds, direct debt and equity mutuals in a given mix. The ratio of asset allocations will have to be reviewed and changed periodically. Setting convenient optimal periods is not easy. Personal life-goals also come into the picture.

Solving these problems are supposedly the core competency of financial planners. But I've rarely come across a financial planner who actually addresses these issues. Most offer one-size-fits-all asset allocation plans based on mechanical consideration of the client's age and income. They often have conflicts of interest. They, or their friends, may also be agents for instruments. If you accept that you cannot beat inflation just by simply investing in debt, you'll have to find a blend of assets that suits you in terms of risk profile and life goals. You'll probably have to do most of the work on your own. It's a tedious task. But it's even more tedious watching your hard-earned savings lose their value.