Invested interest

15 per cent? That’s kind of low, isn’t it?” said the distinguished looking person to whom I had been explaining the arbitrage returns from the Indian markets. We were at a social gathering, and I did not really know him that well. I could only guess from his mannerisms and sophistication in social etiquette that he would also be well-educated about financial matters. “I really look for returns of at least 20-25 per cent. Itna to real estate mein hi nikal aata hain”, he concluded with the confidence of a seasoned buyer of several apartments.

I could not bring myself to point out right then that the volatility of the arbitrage fund was only 2.5 per cent annually, whereas real estate prices can stay flat or go up 25 per cent. I could bring to his notice that the arbitrage fund can be liquidated at any time, whereas converting an apartment into cash is no mean feat. Suffice to say that I could have gotten into a debate with him, but I let it pass as the poker table was waiting. Neither was the place nor the moment right to delve into the details of returns adjusted for risk, liquidity and total costs.

People tend to focus a lot on the returns and not on the other characteristics of their investments. The obvious primary concern besides returns should be the risk attached with the investment. Risk and returns actually go hand in hand. We all understand that 10 per cent returns from a bank fixed deposit is not directly comparable with 20 per cent returns from an investment made in a Mid-Cap stock idea we got from a brother-in-law. Risk is typically measured as the variability of returns. Thus, a bank fixed deposit with sureshot 10 per cent returns versus a Mid-Cap stock that could return 30 per cent or lose 10 per cent have very different risk-return profiles.

However, the problem is that the risk and returns for risky investments are not known upfront, and have to be estimated. Most of us do not really do a good job of correctly estimating the risks and the expected returns. As the famous saying (variously attributed to Niels Bohr, Albert Einstein or Mark Twain) goes, “It is difficult to make predictions, especially about the future”.

Noted researchers, Tversky and Kahneman, had shown way back in 1974 that people tend to make major errors in estimation. First of all, they are heavily ‘anchored’ in their expectations. In the area of investment, anchoring can be to the most recent returns. That is to say that if a stock went up by 20 per cent last year, we start with an assumption that the returns will be about the same in the current year too. We are incapable of making sufficient adjustments to the anchored estimate based on the information that we have or can easily get. For example, we would tend to expect the returns to be plus or minus five per cent, even though historical records may show that the actual range may vary from -30 per cent to +70 per cent.

The second issue is that of liquidity. Most people are only concerned with the absolute returns, and assume that the money will be available as and when required. Only in times of crises do we realise that having a lot of illiquid investments does not do you much good if you do not have the cash required to meet your obligations. While it is true that real estate investments may have returned 20 per cent on an average over long periods of time, consider what your realised return would be worth if you needed the cash in a hurry. A lot of real estate developers have discovered, much to their dismay, that assets do not equal cash.

Finally, we come to the total costs. We need to take care of the transaction costs (for example the stamp duty in the case of real estate) that are involved in our investments. What look like attractive returns can quickly become mediocre or even poor returns once you consider the total costs of transaction. The normal costs of brokerage, transaction and stamp duties must be considered. Even more important are the market impact costs. Market impact costs refer to the cost of getting out of a position. Let us say you own an apartment and want to sell it in a hurry to raise some cash. The price you will get will certainly be lower than the price you would get if you had some time to wait for the right buyers. The difference in the realised price versus the fair price is the market impact. Similarly, when selling stocks, if you have to sell in a hurry and the stock does not trade a lot of volume, the price will fall as you start selling. This risk is particularly significant in Small-Cap and some Mid-Cap stocks. Finally, there are the taxes to be considered. Whether you are going to pay long or short term capital gains or even business income can make a huge difference to your post tax returns.

So, the next time someone tells you that a particular investment idea is going to generate 25 per cent returns, don’t forget to ask them about the risk involved, the liquidity constraints and finally, the total transaction costs.