Read: The Illusion of Low Risk.

“A person often meets his destiny on the road he took to avoid it.” – Jean de La Fontaine

Funnily, the above quote came to me through a recorded movie; I am not really fond of French poetry. But it triggered a thought – that this seems to be what we’re doing in the whole financial world recently, and as an addition, it seems like we expect to die before we meet our destiny.

Take Aditya Birla Money. According to Forbes, ABM sold investors a “risky options strategy” called Options Maxima as a safe investment; and later, when the market took a steep upturn, lost 103 crore rupees! The problem? The feeling of high returns for low risk. In the last year prior to September, the market had stayed in a fairly narrow trading range, so it had been very profitable to write “option strangles” – positions that would make money if the market stayed in that range but lose an unlimited amount if it went beyond. From October 2009, I have heard of brokers and high net worth individuals doing this as a planned strategy – writing strangles such that they made some money if the Nifty stayed within a range as wide as 4000 on the lower side, to 6000 on the upper side. With the Nifty firmly ensconced in the 4800 to 5300 trading range, they made money for a number of months, and the strategy seemed like shooting ducks in a barrel.

Since then, multiple PMS products have come forth with such a strategy, and as it happens when everyone piles on, the yield on the trade dropped drastically. The response? Use a narrower range, and leverage up to get higher returns. Eventually in September, the Nifty shot up way beyond and crossed 6000, making these option strangles lose enormous money – especially because they were highly leveraged. If they were less leveraged, they wouldn’t make the return they wanted – upwards of 2% a month – and which the brokers nearly guaranteed because, look, this strategy hasn’t lost money for a year.

It doesn’t really take a black swan event to unravel things like this. A black swan is an event that you couldn’t foresee from the known past, reflecting the belief that swans were synonymous with the colour white until the day a black variety was seen. This Nifty move of about 11% in a month isn’t a black swan – just in May 2009, the election furore took the Nifty from 3600 to 4200 in one day – a move that triggered the market circuit breakers on the upside. Ignore that? Well, in October 2008, just two years ago, there was a 10% down move in a single day. And again in Jan 2008. And once more in October 2007. If large moves have happened overnight four times in two years, and you have a strategy that loses big amounts of money on such large moves, it is foolish to call it “safe”.

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Ireland asked for a bailout a few days ago. The nation wants to fund its beleaguered banks, whose debts are way higher than their liabilities – and the reason they are in trouble is that they offered cheap credit and funded a housing bubble, which has crashed. The bailout, though is not just of the institutions in Ireland; Morgan Kelly notes that in an indirect way, money has been borrowed to pay back foreign holders of Irish bank bonds. And that in effect, the Irish state is insolvent – so adding in the bailout money at the 5 percent rate that Greece got will render Ireland bankrupt not now, but surely in a few years. To an observer, it seems like they have kicked the can a little bit further down the road. It’s a choice between letting Ireland go down now – and handle the potentially massive consequences to the non-Irish banks and countries – or to fund them around 100 billion euros to let them last a little longer and hope the world ends before they go down again. For investors, it might seem like a low risk trade – let’s all invest in European country bonds because, hey, everyone’s getting bailed out, so we’ll surely get our money back.

Remember, the bailout Greece got was another 100 billion euros. Like the saying goes, famouslymisattributed to Senator Dirksen, “A billion here, a billion there, and pretty soon you’re talking real money”.

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In a trip to Goa last week, I was at the casinos, watching and playing a more sober version of the stock market. The games are terribly against you in terms of odds – engineered in such a way that you think you have a good chance, but if you play long enough you will lose. The simple idea must be to play money you are happy to lose, and if you win, continue on the same bet sizes, or walk away. But thethrill of looking at the big wins often overshadows the gloom and despair of those that lost, which is justified by “I had a great time anyway”. This “win-win” feeling is magnified by casino authorities using various bells and chimes for attracting attention to winners and paying in cash (people associate big wads of cash with lots of money, when often a single sheet of paper may be worth far more). You then justify playing more – after all, you will win sometime, and on the downside it’s just a little more money. A billion here, a billion there….

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Chasing low risk is fine, but anything that shows high returns for abnormally low risk should be viewed with suspicion. As a rule of thumb, anything that gives you higher returns than the best bank deposit you can find probably involves hidden levels of risk. Understanding risk is a complex concept – and it’s better to take a simple product if you don’t have the time to analyze something in detail, or understand that there may be better alternative products with the same risk profile. For instance, in the last few months, short term debt mutual funds have given a return of 7% or more; these are much higher than fixed deposits for the three to six month term, and expectedly so – as RBI increases rates, shorter term money gets more expensive first. But if you don’t immediately ask where the risk lies, I wouldn’t advise you to go there. (For the record: short term debt funds may be impacted if RBI decides to free up short term liquidity or drop interest rates – or if there’s a catastrophic financial crisis)

In my view, there is nothing like a zero risk investment – as people holding outer European debt are beginning to discover. Russian debt holders discovered in 1998 that even debt in local currency (rubles) was not beyond risk, even when the government has the power to print money. In that context, there’s nothing that’s risk free, really. We must, in my opinion, embrace risk for what it is – the door to a higher return, and use as an instrument just enough money so we can come and knock again tomorrow.

If we keep thinking about how bad the world is, and that nothing is risk free, we will despair of a world not worth investing in. Instead, it’s best to think everything is a game of chance, like that minesweeper game where, on that first click, you hope and pray that there isn’t a bomb underneath. Unlike real minesweepers though, you do get to play again – and that must be our spirit going forward. Win more when we win, lose less when we lose, and stay in the game.

The Goa trip introduced me to another poem, courtesy my more knowledgeable cousin, by Longfellow. A few of the passages that I absolutely loved:

Tell me not in mournful numbers,

“Life is but an empty dream!”

For the soul is dead that slumbers,

And things are not what they seem.

Lives of great men all remind us

We can make our lives sublime,

And, departing, leave behind us

Footprints on the sands of time.

 

Now, tell them about it: