Investment Risks That Are Not Worth Taking

Bearing risk is an unavoidable aspect of investing. Investment return is the reward earned for bearing investment risk. Not bearing risk means our money would not grow. But this does not mean that we take risks indiscriminately. We must ensure that we only bear reasonable risks. A reasonable risk is any risk where :

1. The chances of a positive outcome are more than 50%

2. The potential reward is commensurate to the degree of risk and effort involved.

Most forms of investment risk are reasonable and manageable. But there are certain risks that can never be justified as reasonable risks. They must therefore be avoided at all costs. And today I am going speak about such unreasonable risks in detail.

Stock Trading And Derivatives

These strategies are often seen as quick fixes to create wealth. But they invariably send investors into financial ruin. We often see a number of stories about people going from rags to riches by undertaking these activities. This is what creates interest in them. But for every such case, a number of riches to rags stories can be found. But they are never aggressively publicised.

A research paper released by SEBI in July 2024 shows that 70% of intraday traders lose money. Another research paper released in January 2023 shows that 93% of traders in the equity F&O segment lose money. This clearly points to the fact that trading of stocks and derivatives are unreasonable risks. Therefore there is nothing significant to be gained from indulging in them. Investors would do well to never forget the principle laid out below.

Active Portfolio Management

Active portfolio management mainly aims to build and hold a portfolio that offers a market beating return over the long term. Indian markets today are a lot more well regulated compared to a few decades ago. Information and insights about investment products are a lot more easily and quickly available. Investors would not have access to exclusive insights about investment products. Therefore there is significantly lesser scope to beat the market return over the long term at present. This is borne out in a fundamental principle of finance known as the Efficient Market Hypothesis. I have covered the hypothesis and the concept of market efficiency at length in an earlier article Defensive Investing Decoded - I : Conceptual Framework.

Active portfolio management demands two things in significant proportions from the investor. These are knowledge and time. Virtually all of us are employed in extremely challenging and demanding jobs. The demands of our personal lives are no less taxing. This means we may not be able to offer the kind of knowledge and time required for effective active management of the portfolio. When we cannot meet the demands of a particular strategy, it is best not to follow it. We would only derive suboptimal results if we do.

Successful active management also requires effective diversification of the portfolio. But doing this is a challenge in itself. nvestors would have to identify winning products within each asset class in advance during each period. They would then have to gain adequate exposure to them in their portfolios. But this is extremely hard to do correctly and consistently. But for the sake of discussion let us assume that this is somehow achieved.

Investors would next need to accurately predict market outcomes. The market for any asset class is a system of human beings coming together to transact products within the concerned asset class. To predict the outcome of a system, one must understand the behaviour of its underlying components. So beating the market essentially requires investors to understand and predict human behaviour. Most of us know and understand ourselves well. But none of us can accurately predict our own behaviour. Therefore we have no chance of predicting the behaviour of lakhs of other investors around us.

So the potential reward of outsized gains may not be worth the effort involved. All of this points towards the fact that active portfolio management is a futile exercise. There is hence no point indulging in it.

Outsourcing Active Management To Professionals

The prerequisites for superior active management are the possession of better quality knowledge and insights relative to other investors. There is therefore an apparent case to be made for outstanding active management to professional fund managers. This is because professionals would seemingly possess the prerequisites for successful active management. But that is not the truth. Today's markets are a lot more efficient. Most professionals within the financial services industry therefore all have access to similar information and insights. So the performance of most active fund managers in the industry would be similar to each other. This means that there is no inherent source of outperformance available to professional active managers.

The only source of outperformance available to a competent active manager today would be the underperformance of other active managers around them. This effectively means that any outperformance achieved through active management is attributable to luck rather than skill. And therefore, if a professional does achieve genuine outperformance, it does not sustain for long.

This fact is further supported by data from SPIVA India reports. The latest edition of the report (SPIVA India Mid Year 2025) shows that 73% of actively managed large cap funds, 87% of ELSS funds, 82% of mid and small cap funds, 82% of government bond funds and 97% of composite bond funds have underperformed their benchmarks over the preceding 10 year period. This is borne out in the graphic below taken from the report.

We must also remember that actively managed funds come with significant costs. These costs are usually justified through the promise of market beating returns over the long term. But the data has clearly shown that most funds fail to achieve the advertised objective. This makes outsourcing active management another instance of an unreasonable risk. The potential reward is not worth the risk and effort involved.

Investing In Unregulated Assets

Unregulated assets refer to those assets where no legal recourse is available to the investor in the event of suffering losses or frauds on the asset. The best example of unregulated assets are cryptocurrencies. Cryptocurrencies are touted to be the future of currencies. But right now they are ineffective as a medium of exchange. The same can be said for them as a store of value. And these are primary functions of any legal currency.

It would therefore be wrong to view them as a legal currency. Some may argue for the relevance of cryptocurrencies as investment assets. We must remember that all investment assets are either real assets or tied to an underlying real asset. For instance residential properties are real assets. Stocks are tied to the underlying company they represent. Cryptocurrencies on the other hand are not real assets in themselves. They are also not tied to an underlying asset.

This makes it impossible to measure the actual value of cryptocurrencies. There is nothing against which to gauge their value. In fact, this just shows that any movement in cryptocurrency prices is purely speculative. This is quite similar to the Tulip Mania era witnessed in the Netherlands. It saw tulip prices surge from 1634 before subsequently cashing in 1637. In fact, the former governor of the Reserve bank of India, Mr Shaktikanta Das actually drew parallels between the two during a meeting of the RBI's Monetary Policy Committee in February 2022. It is a warning for those who hold cryptocurrencies.

Moreover income from cryptocurrencies is heavily taxed at 30%. Add to this the fact that they are unregulated. All of this makes it clear that there is no logical case for holding cryptocurrencies. This absolutely makes investing in them an unreasonable risk.

Investing In Structured Products

Such products combine traditional asset classes (stocks, bonds etc) with derivatives and other non traditional asset classes (art, venture capital, hedge funds etc). This apparently allows the risk profile of the product to be tailored to the specific needs of each investor. The best examples of such products are Portfolio Management Services (PMS) and Alternative Investment Funds (AIF). A brief comparison of the features of both these products is laid out below.

The differences tabulated above highlight a few key issues that are common to these products. Both these products are very capital intensive. Liquidity may also be a concern. This is especially true for AIFs. But there are more pertinent issues which investors must be concerned about.

Both these products carry fixed charges of 1.5% to 2% per annum. This is significant in itself. Annual costs of just 1% per annum are enough to severely deplete a portfolio. This would severely impact our prospects of securing essential financial goals such as retirement. This is borne out in the following quote from Nobel laureate William Sharpe.

Moreover such products invariably also charge performance fees. These are charged over and above the fixed annual fees. They are charged as a percentage of the profits earned above a certain hurdle rate (20% of profits earned above a hurdle rate of 10% for instance). These just cover the costs that are explicitly declared. There are also hidden costs that are borne by investors.

PMS investors are taxed on dividends and gains booked by the portfolio manager. PMS returns that are publicly reported are usually pre tax returns which ignore this liability. So post tax returns in PMS are lower depending on the investor’s tax bracket and the turnover of the PMS scheme. AIF investors may also bear expenses such as brokerage, custody and (GST) on the fees. These products therefore drain more from investor portfolios than they add to it. This makes it clear that structured products are not worth the risks and costs that they come with.

Final Takeaways

Investors must not expect to profit if they do not bear investment risk. They must also not expect to be compensated just because they are willing and able to bear a high degree of investment risk. Bearing moderate risks in accordance with a clear plan would be sufficient to secure most financial goals. And that is the foremost objective of managing our finances. There is therefore no point in bearing unnecessary risks. All of the risks discussed above outweigh the potential rewards on offer for bearing them. Bearing these risks would more than likely result in permanent loss of capital. They must therefore be avoided at all costs.