We generally use the phrase ‘high risk, high return’ and sometimes, by interchanging the sequence, ‘high return, high risk’. The complete phrase here could be: To increase the portfolio return by a certain amount, one may need to take additional risk. That is termed as risk premiums. A risk premium is the investment return that an asset is expected to yield in excess of the risk-free rate of return. An asset’s risk premium is a form of compensation for investors, representing payment to investors for tolerating the extra risk in a given investment over that of a risk-free asset.
These risk premiums are not constant during all times; they vary with time. At times, the return may increase in tandem with the increase in risk. At other times, the return may increase by less or a higher amount than the increase in risk.
The first-level thinking says that since the company’s future prospects are very good and earnings are robust, it should do well; let me buy it. But if the masses start believing and acting the same way I do, the stock price is overvalued soon. Because the stock’s supply is limited and there is too much money chasing this limited supply in a very short time. Hence, the stock starts trading above its intrinsic value, and risk premium reduces.
Conversely, when there is negative news and masses start selling in panic, the stock’s price falls sharply and starts trading below its intrinsic value— more than accounting for the bad news which the masses would have expected. Hence the risk premium increases. Therefore, when sentiments are positive, risk premiums are low. And when sentiments are negative, risk premiums are high. The same fact about how the risk premium changes over time is nicely explained by Howard Marks thus: First, when a few forward-looking people begin to believe things will get better; Second, when most investors realize improvement is actually taking place. Third, when everyone concludes things will get better forever.
Currently, India is the world’s fastest-growing economy. It may become the third-largest economy by 2030, inflation is in control, crude prices are lower, GST collection is increasing, there is an expansionary fiscal stance, higher consumer spending, and hence higher earnings growth for corporates. Such an expansionary cycle may be for multi-years or for a full decade or decades. Just like the above quote by Marks, few people would have anticipated this scenario in 2020; many have believed the same by 2022 and 2023, and the masses would start believing in the same in 2024. Hence the risk premium starts reducing in each of such stages.
In the current financial year, the large-cap category experienced a net outflow of ₹4,949 crore, whereas the small and mid-cap categories combined received a total inflow of ₹51,442 crore ( ₹17,339 crore for mid-cap and ₹34,301 crore for small cap). In the hybrid category, the aggressive hybrid category saw an outflow of ₹1,337 crore, while the dynamic (balanced advantage) and multi-asset allocation categories received ₹6,446 crore and ₹19,249 crore, respectively. These flows are reflecting positive sentiments for riskier category and negative to neutral sentiments for conservative categories.
While the Indian economy is just like an expressway, it’s not the road, but reckless driving that can make it riskier. Fatal accidents mostly happen on the expressway and not on congested streets. When everyone is driving at 120kmph, it is very difficult for someone to drive at 80kmph.
Similarly, when your investment portfolio is delivering returns above expectations to meet your goal, there’s no need to add further riskier assets. Or else if the riskier asset’s weight is above your strategic asset allocation because of the recent rally in equity and more precisely in small- and mid-caps, investing fresh money into conservative assets is a wise decision. In a nutshell, adding fresh money in hybrid products like balanced advantage fund, balanced hybrid fund, and especially multi-asset allocation fund with considerable allocation to debt and gold is a wise idea.
In India, when the roads are like an expressway, it is important to drive in cars that have airbags and your seat belts fastened, which helps one to avoid mistakes and at the same time protect oneself from someone else’s mistake.
Chirag Patel is co-head – products, WhiteOak Capital AMC.
Unlock a world of Benefits! From insightful newsletters to real-time stock tracking, breaking news and a personalized newsfeed – it’s all here, just a click away! Login Now!
Download The Mint News App to get Daily Market Updates.
More
Less
Published: 23 Jan 2024, 11:51 PM IST
