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All investments carry market risks
Published On , 8 Aug 2017 By Times Of India
Last week, India’s largest bank cut the rate of interest on savings deposits to 3.5% from 4%. Other banks followed. For over six years interest rate on SB deposits was at 4% or above. The decision was based on two market factors: Low inflation and high real interest rate. This sent shock waves among investors. This cut in SB deposit rate is another example that it’s not only mutual funds, even the safest of the deposits carry market risks.
Prices of stocks, bonds, gold, silver, real estate, commodities fluctuate on a daily basis. So naturally mutual funds which invest in some of these assets also witness fluctuations in their NAVs on a daily basis. The risks in mutual funds are risks derived from actual risks which are inherent in assets they buy in the portfolio.
Savings banks, fixed deposits, recurring deposits also carry market risks. In India, each of these accounts is insured for up to Rs 1 lakh. So if you have Rs 2 lakh in a bank account (SB, FD or RD) and the bank is unable to pay, there is a guarantee that you will get half of the money in that account. But the balance half, you may get or it may be lost forever. In effect each SB, FD and RD account of above Rs 1 lakh also carries market risks.
MARKET RISKS REFER TO THE POSSIBILITY THAT NUMEROUS FACTORS COULD AFFECT A MARKET, LEADING TO LOSSES FOR AN INVESTOR
BOND PRICES, INCLUDING GILTS, ALSO FLUCTUATE ON A DAILY BASIS DUE TO MARKET FACTORS
STOCK PRICES WITNESS SWINGS ON A DAILY BASIS
MARKET RISKS INCLUDE CHANGES IN INTEREST RATES, INFLATION AND EXCHANGE RATES, RECESSION, POLITICAL UPHEAVALS, TERRORIST ATTACKS, NATURAL DISASTERS ETC
IN THE LAST FEW YEARS, GOLD AND SILVER PRICES HAVE DIPPED DUE TO POOR DEMAND AND WEAK MARKET CONDITIONS
REAL ESTATE PRICES IN SEVERAL PLACES HAVE ALSO EITHER FALLEN OR STAGNATED IN THE LAST FEW YEARS
BANK FDS, RDS, ACCOUNT DEPOSITS OF ABOVE RS 1 LAKH ALL CARRY RISKS OF NON-PAYMENT
WHAT’S YOUR GAIN-LOSS RATIO?
The bias that we will discuss today has wide implications on investment decisions which we take to achieve our financial Goals. It’s called ‘loss aversion’ bias. This bias also encompasses all options and choices we face in life whenever there is a possibility of ‘mixed’ results: There is a risk of loss and also an opportunity to gain. Entrepreneurs who evaluate a start-up, litigants who wonder whether to file a lawsuit or not, army generals who wish to consider an offensive against the enemy, politicians who wish to contest the election to run for office, all face the possibility of victory or defeat.
Suppose you are evaluating a decision to invest 100. Here the upside is that it can appreciate to Rs 110, if conditions favour. Under unfavourable conditions, however, it may depreciate to Rs 92. Will you invest when the probable gain is Rs 10 and the probable loss is Rs 8? One should balance the psychological benefit of gaining Rs 10 against that of losing Rs 8. Although the expected value of the gamble is obviously positive you stand to gain more than you can lose__most people dislike the former. The fear of losing Rs 8 is more intense than the hope of gaining Rs 10. Losses loom larger than gains as the pain of losing Re 1 is much more than the pleasure of gaining Re 1. This is loss aversion bias which refers to the smallest gain that I needs to balance an equal chance to lose Rs 100. For many, the answer is about Rs 200, twice as much as the loss.
Several experiments have estimated the loss aversion ratio, which usually comes in the range of 1.5-2.5. This is an average and could differ depending on individual traits. Some people are more risk averse than others. Risk takers in the financial markets are more tolerant of losses and they may not respond emotionally to every fluctuation in the market.
Yours Behaviourally is a monthly column on psychology that impacts our investment decisions. R Raja is with a leading domestic fund house.
GLOBAL FINANCIAL CRISIS SHOWED US ALL INVESTMENTS CARRIED RISKS
Here is what happened between 2007 and 2009 due to reckless home loans practices in the US in the preceding years
Real estate prices witnessed severe crash in the US and many other parts of the world after the subprime bubble burst and plunged global markets into a financial crisis not seen since the days of Great Depression in 1929
As global financial crisis spread, Gold being a hedge against risks, its price jumped from a low of about $830 per troy ounce in Aug 2008, to an all-time record high near $2,000. Then it crashed again to $1,100 by December 2015
From a high near the $150 per barrel mark in June 2008, crude prices dipped to below $30 level by early 2016.
Globally Stocks plunged by up to 70%. In about 13 months, the sensex crashed from above 21,000 to below 8,000 while Dow Jones Index in the US nearly halved from close to 14,000 to just above the 7,000 mark.
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