Why return of capital is more important than return on capital

Many investors fail to worry about return of capital instead of return on capital. When Maruti Suzuki came out with its campaign – ‘Kitna Deti Hai?’ it tapped the nerve of an Indian mind-set. Return on capital is the buzzword that rules the world of investments. Many end up chasing returns at the cost of capital. Here are five factors that would help you to reduce the chance of loss of capital.

Temporary loss of capital and permanent loss of capital
Before we get into the details of how to ensure return of capital, let us understand risk. Warren Buffett has captured the essence of investments with two rules: First, do not lose money and second do not forget the first rule.

In traded markets, the prices of stocks, bonds and mutual funds fluctuate almost every second. You buy a stock say at Rs 100 and the next moment the tick shows a value less than that. Volatility-led losses or marked to market losses in the short-term should not perturb you. This is a temporary loss of capital.

What you should be really worried about is the permanent loss of capital. For instance, when a company goes bankrupt, equity shareholders may get little after the process of liquidation goes through.

The underlying risk
Long-term prices rise in line with earnings of a company. It is best to avoid companies that are seen misallocating money to business generating low return of business.

Though mutual funds’ past performance do not guarantee future returns, some investors prefer to look at drawdowns by individual schemes over the desired timeframes before committing capital. Some prefer to look at volatility and choose uncorrelated schemes to build their mutual fund portfolios. While stocks and equity mutual funds do come with a high level of risks, bonds offer a helping hand.

While investing in bonds one can refer to the bond's credit rating. AAA rating (read as triple A) issued by a credit rating agency such as Crisil, CARE, ICRA or Brickwork signifies least risks. As you go lower on the rating curve, the risk increases. Crisil Default Study 2017 states that no long-term instrument rated AAA by it has ever defaulted. However, 0.02 percent instruments rated AA have defaulted during 2007-17. A default by issuer of a bond leads to permanent loss of capital.

However, credit ratings do not remain the same. They change with changes in the fundamentals of a company. Around 95.3 percent of Crisil AA ratings remained in that category at the end of one-year; 1.2 percent were upgraded to Crisil AAA and 3.5 percent were downgraded to Crisil A category or lower.

When the rating of a bond goes up, its yield falls and price go up leading to marked-to-market gains for investors. The same reserves on a rating downgrade.

If the issuer does not default, the bond investor gets his money back at the time of maturity. While the investment process is fraught with many risks, a few precautions may help. Here are a few means to ensure return of capital:

Ignore noise

Wherever you may be investing - stocks, bonds or even mutual funds, learn to control your emotions. Seth Klarman, renowned value investor and portfolio manager of Baupost Group, is often quoted as saying that over the long run the crowd is always wrong. It has been observed that retail investors enter an asset class when it is quoting at peak valuation.

It is better to invest as per your asset allocation based on your financial goals and risk appetite. Timely re-balancing of your asset allocation helps you to overcome your emotions. That helps in avoiding incorrect investment decisions that cost you your capital.

Diversification
Putting all your money in one stock or one scheme exposes you to high risk. Instead it makes sense to invest in a diversified portfolio. You may choose to invest across asset classes. Though diversification does not guarantee return of capital, it reduces the chance of permanent loss of your capital.

“When you invest some money in less risky investment asset classes such as fixed income, you are assured of some returns. While investing in risky assets such as stocks, if you diversify across stocks, the portfolio volatility also goes down,” Jitendra Solanki, Founder and CFP at JS Financial Advisors, said.

Timeframe
In the words of Klarman, the single greatest edge an investor can have is long-term orientation. It has been observed that the possibility of loss reduces as the holding period increases in case of equity investing.

"If you are investing in equity mutual funds for high returns, opt for a systematic investment plan and invest for long-term in schemes with proven track records to ensure that you reduce risk of permanent loss of capital,” Ajay Kinjawadekar, Founder of Money Safe Financial Services, said.

Regulated products
At most times, individuals try to get into unchartered territory while chasing returns. For example, many investors are turning to stocks for the first time in a chase for higher returns leaving behind conservative options such as gold, bonds and fixed deposits. In such a situation if one does not have an idea of picking stocks for himself, it is better to opt for a regulated means such as mutual fund to invest in stocks.

Regulated products such as mutual funds and unit-linked insurance plans (ULIPs) are better ways to invest in traded markets as there are some mechanisms in place to protect investor interests. “Regulated entities such as Sebi registered investment advisors are responsible for the advice they give to their clients,” Solanki said.

Expert hand holding
Many a times the lack of time or lack of skills land investors in trouble. Instead of venturing on your own, you may want to engage the services of professional investment advisors and fund managers to ensure that there is a scientific approach in your investments. “When you invest through an expert, the risk associated with individual asset classes are better managed. You end up making better risk-adjusted returns,” Solanki added.

Though this should reduce the chance of permanent loss of capital, it does not guarantee return of your capital. It is better to keep reviewing your investment decisions at regular intervals.