We are all aware of the 'high risk' and 'high return' associated with investing in equity. It is this 'high risk', which has usually kept an average investor away from equity in India.

Equity as an asset class accounts for barely 2-3% of the total investments in India.

The interest rates in India have appreciably come down in the last 2-3 years. And given today's tax structure and the inflation numbers, the post-tax post-inflation returns from a debt investment works to almost zero or even negative. This is forcing an average risk-averse investor to take a look at equity.

Given this scenario, is it possible for a small and average investor to earn better returns without taking high risk which may seriously affect the safety of his capital? Can equity be a viable option?

Let us first analyse and understand the risk of investing in equity. Broadly, one could say that an equity investment is exposed to 3 kinds of risk. These are:

1. Market Risk: The company in which we are invested is doing quite well and has also given good guidance for the next year, e.g. Infosys [Get Quote]. But the market as a whole falls due to some negative sentiment -- say oil prices are soaring, there is a change in the government, monsoon is bad this year, etc. In such a situation the market as a whole can fall. Consequently, the share price of Infosys could also fall and result in a loss to us.

2. Company Risk: We did our research and invested in a scrip, for example ONGC [Get Quote]. The company performed quite well. But, subsequently there was some government intervention and it had to bear a part of the subsidy burden. It was not allowed to pass on all the increased cost of crude to its end-users.

This affected its profitability, the share price and thus our investment. Or may be the company we invested in did not perform as per market expectations and hence its share price fell. Or a particular scrip could be illiquid or thinly traded.

3. Cheating Risk: Cheating has been a very common phenomenon in India. We regularly have had scams in the stock market, which has seriously dented the confidence of an equity investor. We were lured into investing in a company, which was inherently bad.

But it did not disclose the events, which would seriously affect its performance going forward. Hence, by the time we are aware of the negative news the share price has already fallen and we end up making a loss. Or say the price of a particular scrip was manipulated.

Since the past scams, however, the regulatory agencies and stock exchanges have introduced a number of systemic improvements -- demat, T+2 settlement period, live quotes, margins etc. Also, we now have a lot of institutional players such as mutual funds and FIIs. All this has substantially reduced the probability of payment crisis or a large-scale market manipulation, etc.

Market Risk and Company Risk are, however, genuine risks and are part and parcel of equity investing.

The company risk can be effectively reduced through diversification of one's portfolio -- either directly or through mutual funds. This would ensure that a bad performance in a few scrips will not affect the overall returns significantly. It also further reduces the cheating risk.

However, in a diversified fund a fund manager could be following an aggressive strategy or is bullish on a particular scrip/sector or is taking a call on a mid-cap/small-cap. This means that some level of company risk still remains in a diversified fund, despite the diversification.

Index funds, which invest only in index scrips and in the ratio they comprise the index, considerably reduce the company risk. Further, these are very large cap stocks, which are extremely difficult to manipulate. Also, their corporate governance levels are quite good, reducing the cheating risk further.

Thus index funds, more or less carry only the market risk.

Index funds offers certain other advantages too:

• The expense ratio is quite low around 0.5-1.25% vis-�-vis around 2.5% for a diversified equity fund.
• The fund manager has no role to play. The entire investment is as per the weightages in the index.
• They are easy to understand for everyone. Thus one can easily decide for oneself whether it fits into our investment profile or not.

Hence, if one is confident of the India Shining story; if one is confident of 7-8% GDP growth over the next 2-3 years; if one is confident of the consequent growth in the corporate profitability, then over the next 2-3 years the index could be expected to grow at least 12-15% p.a.

Accordingly, investing in an index fund could be turn out to be a comparatively low risk, decent return, defensive strategy of investing in equity.

The author is an investment advisor and can be reached at sanjay.matai@moneycontrol.com

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