Don't just look at return, consider risk too while deciding on investments

Last week came the news that yet another investment firm has allegedly defrauded its investors, among them a famous sports personality, to the tune of Rs 4 billion. This investment firm had promised investors returns of 23-25 per cent. What boggles the mind is how any entity can get away by promising a return that is almost four times the current State Bank of India one-year fixed deposit (FD) rate of 6.40 per cent.

This is not the first time that investors have fallen for such false promises, and will certainly not be the last. The question that arises is why such scams keep happening with unfailing regularity in India, and why the literate strata of our society in particular falls prey to them. Do we not understand that risk and return go hand-in-hand, or do we, in our rush to get rich, simply choose to ignore risk?

Returns act as compensation for investors bearing risk. Technically, one  should not use the term returns, but expected returns, which is what we expect (or hope) to earn from an investment. 

To incentivise investors to invest in the second investment, it should offer an expected return greater than 6.40 per cent. Would your answer change if the second investment were to give you a return of 25 per cent with a probability of 0.50, and a return of -2.20 per cent with a probability of 0.50? The expected return is now 8.9 per cent. You are getting a compensation of 2.50 percentage points above the riskless FD rate of 6.40 per cent. This is the compensation, called risk premium, for bearing the uncertainty present in the second investment.

Over the past decade, our stock market indices have yielded a cumulative annual growth rate of around 10 per cent. Comparing it to our riskless FD rate of 6.40 per cent, the stock indices have a risk premium of 3.60 percentage points. When someone offers a return of 23-25 per cent (as in the above-mentioned case), the risk premium is between 17 and 19 per cent, which implies that it is an extremely risky investment.

The most important questions to ask when someone promises you a return far greater than the FD rate is how they will earn that kind of return, what investment strategy they will employ, where they will invest the money to get the promised, and what is the risk.

How Ponzi schemes work: When someone promises you a return that is far greater than the riskless FD rate, in all probability he is running a Ponzi scheme. Ponzi schemes work in the following way. I ask you to invest Rs 100 and promise to, say, double it in a year’s time. I have no intention of investing your money. I simply use it for my personal benefit.

A year later, I have to pay you Rs 200. What do I do? I approach two new investors (call them A and B) and ask them to invest Rs 100 each with a promise to double it in a year. They believe me and give me Rs 100 each. I pay you the Rs 200, out of which I charge a fee for keeping my promise.

I wait for another year and then realise that I need to pay two people Rs 200 each. I approach four new investors, (call them W, X, Y and Z) and ask them to invest ~100 each with the promise to double it in a year. I use this Rs 400 to pay off A and B but again charge a fee. Then in the third year, I approach eight new investors for Rs 100 each, which I use to pay Rs 200 each to W, X, Y and Z. All this while, my reputation as a genius investor is growing. You have told your family and friends about me, as have investors A, B, W, X, Y and Z.

In a few short years, everyone is falling over each other wanting to invest their money with me. I keep charging all investors a fee for my troubles. Imagine how much I will make if we are talking about millions rather than the hundreds of rupees in this example. 

There is a lot of academic research that shows that all Ponzi schemes collapse eventually, which is when they come to light and get coverage in the mainstream media. The most famous of these Ponzi schemes in recent times was run by the former chairman of Nasdaq in the US, Bernie Madoff, who is currently serving a 150-year jail sentence. The estimated size of his fraud is close to a whopping $65 billion.

Another constant refrain I hear is that investment companies claim they can promise high returns because they invest the money in futures and options. This is an extremely incorrect or misleading argument because, if anything, investing in derivatives is far riskier than investing in shares. Given their higher risk, their expected returns may be higher, but it cannot be a promised return.

A cricketing example: To further illustrate the risk-return relationship, think about the riskiest shot in cricket. It is the one that tries to clear the boundary, the key word being ‘tries’. Given that it is the riskiest shot, the return is also the highest – it is worth six runs. This is the reason cricketers do not try to hit a six off every ball. They try to do so only off loose balls, thereby minimising risk.

The bottomline is that before making any investment decision, always understand its risk. Ask questions that help you understand the risk in the instrument better. Expected returns should be commensurate to the level of risk. If the person selling you an investment scheme offers a reply like, “Don’t worry about it, leave that to us”, then you should definitely not invest with him.  
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The writer is clinical assistant professor of Finance, Indian School of Business