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This is how risk is defined: "exposure to danger, harm or loss". The dictionary then helpfully gives an example: "the father risked his life to save his twin babies from a fire". Risk by definition, relates to a strong possibility of a permanent loss. Let us contrast this with the definition of volatility: "liability to change rapidly and unpredictably, especially for the worse". We must help investors understand the fundamental difference between risk and volatility, and then proceed to look at equity from a risk perspective.
Equity: strong possibility of permanent loss?
Ask your clients to consider the following statements and tell you whether they agree or disagree:
India is a growing country with inflation and fiscal deficit under control Average GDP growth over next 5 years can be assumed at 6% with an 80% probability Average inflation over next 5 years can be assumed at 5-7% with 60% probability
I don't think we will find too many Indians who dispute any of these statements and the probabilities assigned to them. Then go on with these statements:
It therefore follows that nominal GDP growth should be in double digits (11-12%) with a high degree of confidence. Corporate earnings growth will be at least in line with nominal GDP growth, perhaps at least 2-3% higher based on long term history Equity market returns over next 5 years should therefore be in double digits (12-14%) and well managed equity funds should be able to deliver 2-3% alpha on top of market returns (show historical data to establish both points)
Now, ask your clients to put a probability on the following:
Equity fund returns over next 5 years will be in double digits (12-14%) Equity funds will permanently lose my capital over next 5 years
I am sure we know which of these statements will get high probability scores. So, next time anyone tells you that equity is risky, please take them through this and help them understand the fundamental difference between risk and volatility.
Risk is a function of destination of money
Making a sweeping statement that equity is more risky than debt is incorrect. Risk depends on the destination of the money - and this is where fund managers and advisors play a key role. If you invest your money let say in SBI - you can argue that the money is safe - whether it is invested in debt (SBI deposit) or equity (SBI shares). Risk here has to be perceived from the perspective of probability of permanent loss. On the other hand, if you invest in JP Industries, probably it will be correct to say that debt is riskier than equity!
Taming volatility
Having established that equity is not risky but is volatile is not enough to build investor confidence. That is only the first part. Volatility also frightens investors, because the risk perception becomes high during very volatile times. Volatility causes excessive emotions of fear and greed and is the central cause of investment returns not translating into investor returns - a topic which I have written about earlier on Wealth Forum (Real problem is delivery of product), and (Creating informed or confused investors). Our equity funds have delivered strong alpha over long periods of time - their wealth creation track record is truly commendable. Where we as an industry have failed is not in generating product returns but in capturing those returns into investor portfolios.
This is where our job as advisors comes in - to help investors tide through periods of extreme volatility. The best way to do this is to understand that periods of extreme volatility usually occur during periods of extreme valuations. It is our job to regularly track valuations against corporate earnings and yield gap. When we find valuations too high relative to these parameters, we must proactively advise clients to cut equity exposure, and vice versa. Our job is not to get swayed by market sentiment and market technicals - our job is to remain focused on market fundamentals. Let us not try to become fund managers - our industry has many good managers who are doing their job - let's focus on our job which is about capturing product returns into investor portfolios.
If we proactively rebalance client portfolios by tracking and identifying periods of extreme valuations, you will find that you are delivering a healthy advisor alpha over and above the alpha that the fund manager delivers. You will also find that you are creating tremendous confidence in your clients to remain invested in your actively managed portfolios, since you are showing them how to actually use volatility to their advantage.
For those of us who do not have the bandwidth to implement portfolio rebalancing based on market fundamentals across all client portfolios, we must embrace Dynamic Balanced Funds as the key vehicle to give investors equity exposure. Dynamic balanced funds have changed the investor's perception towards equity, as they address a core issue that was so far not addressed adequately - which is taming volatility. The stupendous success of ICICI Prudential BAF (from 250 crs to over 17,000 crs) and its track record are strong evidence of the value such products add in investor portfolios. There are many more such options that are now available for advisors and investors to choose from - which is great news from an industry perspective.
To conclude
Our task as advisors is two fold: help investors understand that equity is not risky but is definitely volatile and help them deal with volatility in a manner that promotes long term investing. Only education on risk is not enough - we owe a responsibility to our investors to help them manage volatility with either our proactive efforts or proactive efforts of products that are designed to do so.
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