The risk-return tradeoff

Anup Menon

TRADITIONAL wisdom on the risk-return relationship is that the greater the risk associated with an investment, the higher should be the compensation -- otherwise described as the risk premium.

An investment decision should, thus, depend primarily on the returns realised after taking into account the risk. This can be assessed using an indicator of the returns expressed as a unit of risk. The actual number is arrived at by dividing the returns by the variation in returns as measured by the standard deviation of the returns.

Business Line analysed the returns per unit of risk on the Nifty stocks on monthly, quarterly, half-yearly and yearly basis. On an absolute return basis, 20 stocks posted positive average annual returns above the average bank deposit rate of 10 per cent. However, after adjusting for risks, only 12 provided returns over the average bank deposit rate. The best performers, post-adjustment for risk, include FMCG and technology players.

An interesting trend that emerged from the returns per unit of risk analysis was that some of the leading FMCG companies, such as HLL, Britannia, Nestle and ITC, performed well, over the last seven years. Historically, FMCG stocks had lower volatility than some of the fancied sectors.

This is a positive factor for investors in times of volatility. A portfolio of FMCG stocks loses value during periods of volatility at a much lower rate than a portfolio of non-FMCG stocks. This is a fundamental difference between investing in technology and FMCG stocks.

Both the technology and FMCG sectors posted fairly good returns over the seven-year period. However, the risks associated with the former is higher than that for the latter. The reason is fairly simple. Because of the evolutionary nature of the business, the perception of value of technology businesses and the premium associated with companies in this sector vary among market players.

This uncertainty induced by changing perceptions leads to higher risk, as reflected in the price movements. This is evident from the fact that HCL Infosystems and Satyam Computers have monthly return volatility levels of 3.51 per cent and 3.80 per cent respectively.

Compared to this, the FMCG stocks have a lower level of volatility. The reasons could be that the market understands the business of these companies better than it does that of technology firms. Even historically, FMCG stocks have recorded good returns, making them good defensive plays. Consequently, these stocks may be viewed more as defensive stocks, leading to lower speculation in the market. Hence, prices tend to be more stable.

This is evidenced by the fact that Nestle and Britannia have risk levels on monthly returns of 1.71 per cent and 1.41 per cent. Further, the risk level of the FMCG giant, HLL, is around 1.80 per cent, close to the index volatility level of 2 per cent. Hence, HLL may be a good proxy for the index per se.

The only major in the FMCG sector to have registered significant losses is Colgate Palmolive. The company has been losing market share to HLL over the last few years. Its poor price performance can be attributed to this. At the same time, its risk level is close to HLL's.

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Safe options

Among all investment avenues, equity is the riskiest. Theoretically, there is a possibility that at times when the equity market volatility is high, most stocks are going through a volatile phase. This may lead to some investors moving from the high-risk equity class to the lower-risk bonds and bank deposits. In mid-1998, for instance, when the equity market was being hammered down, many investors moved to such safer options treasury bonds.

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India does not have a deep debt market. Most investments in debt securities are likely to be in bank deposits and fixed deposits of manufacturing companies. For instance, the fixed deposit programme of Tata Power, an index-based stock, offers a yearly rate of return of around 11 per cent.

However, over the last seven years, the company's equity returns have been lower than 5 per cent. It goes to show that, in some cases, especially Old Economy stocks, investors may be better off investing in debt than in equity.

Taking a more conservative position, an analysis of the number of stocks that recorded an average annual return greater than the bank deposit rates indicates that only 20 managed to post positive returns. One has to consider the fact that the average bank rate may have been conservative, given the higher interest rates prevailing in the market before 1999. Overall, the indications are that a long-term investment in the equity market may not pay off.

Given these market conditions, a 20 per cent average annual return on equity investments would be an acceptable benchmark. But based on these criteria, only 13 stocks managed to post higher returns on an annualised basis. Among the bluechips that did not make the positive list are ICICI, Larsen and Toubro, Reliance Industries and Tata group companies.

Significantly, a majority of the bluechip stocks in the negative territory were from the economically-sensitive sector. This trend is likely to continue given the general market trends and the current preferences of the institutional investors.