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The riddle of risk vs return

WE ALL TALK about risk, and it is easy to explain it in statistical terms as standard deviation around the mean. However, what does it mean in simple terms' It means if in the long run an investment is likely to generate say 10 per cent return every year what is the likelihood that in one year the return may be zero per cent and in the next 20 per cent. The rule is that the higher the return we want in the longer run, the higher is the risk we will have to take to achieve that return.

No one should be advised to invest all their money in one asset class. Diversification in asset classes will increase your risk/return profile. Let me explain this fundamental investment principle. Diversification means the spreading of risk by putting assets in several categories of investments. It is also an investment paradigm that different asset classes seldom move together. Not all the returns on different assets move together over time.

To the extent that the correlation of return on assets is less than perfect, diversification can bring about either a higher return for a given level of risk, or a lower amount of risk for a given level of return. The average investor can achieve this diversification by diversifying among different classes of assets such as stocks, bonds and cash equivalents. If we were a convertible economy, with the ability to invest in overseas stock and bond markets, we could diversify through investing in securities markets worldwide.

There are three primary factors in achieving performance through asset allocation. These are the process of selecting an appropriate percentage of asset classes for an investment portfolio, market timing which involves varying proportions invested in asset classes to take advantage of perceived trends in market conditions and security selection which refers to the picking of individual investments within each asset class.

Investors often fail to differentiate between diversification, having their eggs in many baskets and asset allocation, having their eggs in the right baskets. I would advise investors to focus attention on assets and markets anticipated to outperform over an intermediate to long-term basis. Market timing, in the other hand, involves moving frequently between assets classes in order to take advantage of short-term market conditions. Historically, this tends to be more risky and expensive.

If you are an investor with large sized assets and require diversification on an ongoing basis, you must engage a professional financial adviser. Investment products like mutual funds and defined asset funds are suitable for investors with both small and large assets. Investors should ensure fund selection is not too highly concentrated in one sector or investment style.

Time in the market, not timing the market is what is critical for investors seeking sustainable returns in line with their risk profile. The opportunity loss suffered while attempting to time the market can be exceptional. Patience and discipline are required so that a wrong move is not made.

(The author is president, DSP Merrill Lynch Fund Managers. The views expressed in this article are his own)

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