X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Look (at the downside) before you leap - Views on News from Equitymaster
 
 
  • PRINT
  • E-MAIL
  • FEEDBACK
  • A  A  A
  • Apr 28, 2001

    Look (at the downside) before you leap

    On February 28th 2001, the Finance Minster presented what was thought to be one of the most market savvy budgets of the decade. Not in his wildest dreams would the FM have thought that post budget all hell will break loose. It did. And when the carnage ended it left behind a trail of bodies. No not of the bulls or the bears, but of the ‘small investors’- as always.

    Not to say that the individual investors were not at fault but they could have never guessed the corruption in the exchanges and complacency of the regulators. Their undoing was greed, to make money as quickly as possible. Somehow it was imbibed into them that stocks exchanges were the quickest route to riches. There objective was simply to maximize their returns. But they forgot one fundamental principle ‘more the risk, more the return’. In other words, if there are unrealistic returns expected, the risks too are unimaginable.

    It is very interesting to note that there is far greater interest in the returns rather than the risk involved. If there was no risk why would any return be more than that the return to government securities? Therefore, investors must appreciate one very simple fact that if they are looking at returns, they need to look at risk.

    Then the question is what is risk? Risk can be explained as a quantification of the outcome not meeting expectations. To put it very simply, things going wrong. Now the problem is how do we measure risk?

    Let us look at a few measures of risk used and how they have evolved over time.

    Volatility
    The simplest measure of risk, which says what is the standard (average) deviation of the values (stock price) from the mean. A measure of how much the returns have missed the mark by. Greater the deviation greater the risk. As this is a statistical concept it is very difficult to interpret. The unit of measurement is percentage (%). The returns should be seen in combination with the standard deviation.

      Standard Deviation Mean returns
    Infosys 3.4% 0.40%
    HLL 2.2% 0.10%
    Sensex 1.8% 0.03%

    Based on daily returns for the period from 15 Dec,1995 to 4th Apr, 2001

    One of the most prolific users of standard deviation was Harry Markowitz. He came out with his portfolio theory and revolutionized the way people selected stocks. He introduced the concept of portfolio risk diversification i.e don’t put your all your eggs in one basket. According to him the combined risk arising from two stocks depended not only on the risk of the individual stocks but also on the how closely their price move together (correlation). Therefore, if two stocks have almost no correlation then the combined risk of the two stocks can be lower than the lowest of both the stocks involved.

    The premise was that same factors would not affect the stocks and therefore, risk would be lower. Probably losses on one of the stocks would be offset by gains on the other stock. Therefore risk was broadly categorized into diversifiable and non-diversifiable risk. The diversifiable risk can be made to disappear by a combination of stocks but the non-diversifiable risk has to be borne by the investor.

    The lesson here is very simple. Don’t put all your money into one sector. What if the sector has a de-rating? Obviously all the stocks of the sector are going to take a hit. The IT sector was recently de-rated as its largest market (the US) was facing tough economic environment and therefore, the IT spend in the US dropped. This meant lower revenue growth for the industry.

    William Sharpe extended Markowitz diversification principle. According to Sharpe, if there was a part of the risk that could be done away with, why would there be returns for it? Therefore, only that part of the risk that cannot be diversified would be rewarded. He decomposed risk into two components. Systematic risk (non-diversifiable) that affects all stocks and is more macro in nature and unsystematic risk (diversifiable) that comprises of the stock specific risks.

    Beta
    Beta is the measure of the non-diversifiable or market risk. It gives a measure of how much would the stock price change if the market moved by a particular amount i.e. the sensitivity of the stock to market movements. Therefore, it quantifies the extent of dependence of the stocks price on the macro or market factors. Suppose a stock has a Beta of 0.5, if the market moves by a certain amount the stock is likely to move by half the amount, as its sensitivity to the market is low. Again if a stock has a beta of 2, then the impact of market movement on the stock is likely to be magnified and be of twice the amount.

      Beta
    HLL 0.68
    Infosys 1.04
    Based on daily returns for the period from 15 Dec,1995 to 4th Apr, 2001
    Both these measures do quantify risk but what have one major flaw that is they do not say what will be the loss in rupee terms and what is the probability of this happening. For example volatility tells us that Infosys is more volatile than HLL and more risky. Also Beta tells us that Infosys is more likely to be affected if the markets move as compared to HLL. But it still doesn’t answer the question that what amount of money does the investor stand to lose. This answer is provided by a measure known as value at risk (VaR).

    Value at Risk
    VaR is generically defined as the maximum possible loss (in Rs terms) for given position or portfolio within a known confidence interval or a specific time interval. There are number ways to measure VaR.

    But basically VaR can be thought of comprising two components.

    • The sensitivity of a portfolio or positions to the change in markets
    • The probability distribution of the markets over the desired reporting period horizon.
    If we combine both the components above then we are able to say with a certain level of confidence what will be the stock price movement in a day.

    Confidence Level 68% 90% 95% 99%
    HLL (VaR) 2.2% 3.6% 4.3% 5.7%
    Var for Rs 10,000 220.0 363.0 431.2 567.6
    Infosys (VaR) 3.2% 5.3% 6.3% 8.3%
    Var Rs 10,000 320.0 528.0 627.2 825.6

    Based on daily returns for period from 15th Dec, 1995 to April 4, 2001

    Here for 68% confidence level that can be interpreted as on 68 days out of hundred the VaR is 2.2% (1 times std deviation) of the portfolio value. For an investment of Rs 10,000, the value at risk works out to be Rs 220. Therefore on 68 days out 100 an investor will not lose more than Rs 220 in a day for an investment of Rs 10,000 on HLL.

    Similarly for Infosys at a confidence level of 99% can be interpreted as 99 days out of hundred the VaR is 8.3%. Therefore, in 99 days out 100 an investor will not lose more than Rs 826 in a day on an investment of Rs 10,000 on Infosys.

    These are just a few methods used to quantify risk. The purpose of this article was to introduce risk as a measure and stress the importance of valuing risk while investing in volatile markets.

    Investing in stock market is not a gamble. But again it’s certainly not a sure way to make money nor is it a sure way to lose it either. Investing calls for lot of research and thinking before you put in your money. Luck can sometimes help you get some easy money but in more than a few cases luck runs out. Therefore, look before you leap. And leap because you know the risk involved not because you got a hot ‘tip’.

    There is no easy way to make money, at least not on the stock markets; not that we know of. If you still think otherwise, best of luck to you. You are going to need tonnes of it.

     

     

    Equitymaster requests your view! Post a comment on "Look (at the downside) before you leap". Click here!

      
     

    More Views on News

    How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

    Jun 10, 2017

    Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

    Why NOW Is the WORST Time for Index Investing (The 5 Minute Wrapup)

    Aug 18, 2017

    Buying the index now will hardly help make money in stocks even in ten years.

    Trump Takes a Beating (Vivek Kaul's Diary)

    Aug 18, 2017

    Donald J Trump, a wrasslin' fan, took a 'Holy Sh*t!' blow on Tuesday.

    How To Read Your Mutual Fund Account Statement Correctly (Outside View)

    Aug 17, 2017

    PersonalFN simplifies the mutual fund account statement for you.

    This Small Cap Can Drive Chinese Players Out of India (and Make a Fortune in the Process) (The 5 Minute Wrapup)

    Aug 17, 2017

    A small-cap Indian company with high-return potential and blue-chip-like stability is set to supplant the Chinese players in this niche segment.

    More Views on News

    Most Popular

    Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

    Aug 7, 2017

    The data tells us quite a different story from the one the government is trying to project.

    A 'Backdoor' to Multibaggers: It's Like Investing in Asian Paints Ten Years Ago(The 5 Minute Wrapup)

    Aug 10, 2017

    Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.

    Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

    Aug 8, 2017

    Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

    Signs of Life in the India VIX(Daily Profit Hunter)

    Aug 12, 2017

    The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

    7 Financial Gifts For Your Sister This Raksha Bandhan(Outside View)

    Aug 7, 2017

    Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

    More
    Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
    Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

    LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

    SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

    Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
    Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407
     

    Become A Smarter Investor In
    Just 5 Minutes

    Multibagger Stocks Guide 2017
    Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
    We will never sell or rent your email id.
    Please read our Terms

    S&P BSE SENSEX


    Aug 18, 2017 03:13 PM

    MARKET STATS