Measuring Volatility

It is common knowledge that mutual funds are benchmarked against particular market indices. In general, diversified funds are benchmarked against Sensex or Nifty, while sectoral funds are benchmarked against their particular sector index. It is fair to then assume that the ups and downs of any index will affect the funds that are bench marked against it. In other words, if the Sensex falls, you can expect a diversified fund to fall as well.

 

But while some funds might be affected more by an index’s volatility, others might not. So, then how does an investor get an idea of how volatile a fund is with respect to its index?

Here is where beta enters the picture. Beta is the measure of a fund’s (or stock’s) volatility relative to the market or benchmark.

For example, if a fund is benchmarked against the Sensex, a beta of more than 1 would imply that the fund is more volatile than the index. And of course, a beta of less than 1 would imply lesser volatility.

Allow us to explain further. Let’s say there are two funds, one with a beta of 2.5 and the other with 0.4, both benchmarked against the same index. Now, if the market rises by 1 per cent, the first fund will rise by approximately 2.5 per cent, while the latter will rise by 0.4 per cent. A similar relationship will take place in a falling market. In simpler words, beta is a quantitative measure of a fund (or stock) relative to the market.

In effect, beta expresses the fundamental trade-off between minimizing risk and maximising return. This means that while an investor can expect high returns from a fund that has a beta of 2, he can also expect the fund to be more risky and drop much more when the market falls. A fund with a beta of 1 would flourish or diminish in the same vein as the market.

So, how effective is beta in judging a fund’s volatility? Well, that depends on the index used to calculate it. If the beta of a large-cap fund is calculated against a mid-cap index, the resulting value would have no meaning. This is because the large-cap fund would not be invested in the stocks making up the small-cap index.

Beta is fairly straightforward and offers a lucid, quantifiable and convenient measure of a fund’s volatility. However, beta does have its limitations. Beta is essentially a historic tool and does not incorporate new information. For example, a company may venture into a new business and assume a high debt level, but this new risk will not be captured by beta. Beta relies on past movements and does not take new happenings into account. Hence, beta cannot be calculated for new funds or stocks that have insufficient history.

 

A cut to conservative Debt investor

Raghuram Rajan has started cutting interest rates and it’s simply impossible to find any comment on it that is not heavily optimistic. Certainly, I’m not about to view coming lower interest rates in a negative light, but simply point out that the impact on savings must be considered. Right now, the focus is on cheaper money for businesses and government and the prospect of higher growth. As far as the impact on investments go, all attention is on the booming equity markets which have welcomed Rajan’s rate cuts with big jumps. The bond markets are also happy. Since we look set for a long period of interest rate declines, bond investors as well as fixed-income mutual fund investors are going to make handsome returns of the kind that they haven’t seen for a while.

 

So who isn’t invited to this party then? Clearly, only those who save in banks and other fixed-return deposits. A drop in interest rates will see a fall in savings bank rates and fixed deposit rates. Not just that, public provident fund (PPF) and post office deposit will also now fall, as will EPF returns. This is inevitable, and is an integral part of generally lower interest rates in the economy.

 

Of course some people will point out that since inflation has fallen, lower interest rates do not mean lower real rates. However, that’s only partially true. The official inflation rates do not reflect the actual inflation that an individual faces. Older, more conservative investors are rarely able to gain any direct advantage from lower rates. What this means is that times of good economic growth are, on a relative basis, implicitly disadvantageous for those who keep their long-term savings in fixed income asset classes. The logic of the time points towards equity. For some, it might be better to take some risk rather than see the real value of their savings whittled away.

Don’t mis-take Financial planning

Financial planning is one of the least understood aspects of modern life. The reason is not hard to find. Till as recently as middle of 20th century people had little reason to plan. Their lives were pretty much one track affairs where all that an individual could do was to start early in life, apply oneself to learning a particular job and raise a family. There were no career changes, jobs were for life, illness often meant death, and inflation was low and economic cycles of boom and depression lasted for decades.

However last 60 years have transformed the economy and the society. Economic cycles are much shorter, jobs are being redesigned as assignments, financial instruments are getting more complex and inflation is a reality. In all of this we have a scenario where what determines the long term prosperity of an individual is not only a function of his intelligence and his earning potential but also how he has planned his finances. Unfortunately the education system is yet to catch up to this new reality and inculcate systematic financial planning as an important education tool.

While proper financial planning is a subject in and of itself, in my experience if a person can avoid a few basic mistakes which I have listed down, then one considerably increases their chances of material well-being. Here is my list:

1.Absence of a clearly defined goal: We all have multiple goals in life for which we need to save. Buying assets, childs education, marriage, our own retirement. A common problem I see is that people have not written down exactly what do they want and how are they saving specifically for the goal. Each of the above goals has a different timeline and risks and accordingly saving plan has to vary.

2.Trying to save post expenses: We see so many people who believe that they simply cannot save. The expenses are too great. The mistakes made by people are that they try to save from what is left AFTER spending. That does not work. Your expense should be accounted for AFTER you have saved.

3.Not taking professional help: In case their car has a flat tyre or they have leaking tap people will not change it themselves and instead rely on mechanic or plumber. But when it comes to planning for their future and well being they try to do it themselves. I find it amusing and sad. Fact of the matter is that the financial world has become so complex and risks are so varied that it is beyond the capacity of most people to plan their financial future. Do not play with your future. Please draw your savings plan with a help of professional advisor.

4.Not taking risks into account: When planning for future are you accounting for what all can through your planning off the track? Death, Disease, Disability can all have a devastating impact on your goals. Untimely death & health expenses are the leading causes of bankruptcy in our country and yet very people seem to plan for these. Sound financial planning takes these factors into consideration and protects you against economic impact of the same.

5.Not reviewing progress: If a person does all of the above then he has taken a giant step towards securing his financial future. However all of the above will come to a naught if the progress is not reviewed periodically. At least set a couple of days every year to review how you are doing against the plan. Minus of this you will be playing blind. Not a good idea.

In essence what I would recommend is please be pro-active, seek professional help and be involved in the process of planning for your future. I am reminded of an old dictum failing to plan is planning to fail. Make sure you don’t fall prey to it.