Can you curb investment risk? - Views on News from Equitymaster

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Can you curb investment risk?

Jun 12, 2013

Webster dictionary defines risk as the possibility of loss or injury. This is a possibility we face in every sphere of our lives. And investing is no different. In investing, the risk comes in the form of the possibility of the returns being different from what we expect or want. In an extreme case it is the possibility of losing part or whole of our original investment.

But equally popular in investing is the concept that with high risks you get high rewards. This is because of the premium that the investment avenue provides investors to compensate them for the higher risk involved. This is the concept that has led many an investor to burn their fingers because they took too much risk. Therefore there is a need to balance and manage your risk properly.

To understand how to do this, the first step is to know what the various risks that influence your investments are. All investment related risk can be broadly classified under four categories.

  1. Company specific risk - These are the risks inherent to the company. Company specific risk includes operating history, management depth, access to resources, customer diversification, purchasing power. These are risks that would affect the company's operations and reputation. From the abovementioned examples, one thing is quite clear. Not all of these risks can be quantified. Therefore, investors need to use several qualitative factors to understand the extent and nature of this type of risk. If you don't factor in this risk, things could go terribly wrong. Remember the case of Satyam or even Suzlon Energy for that matter. They are classic examples of how company specific risk could destroy shareholders' wealth.
  2. Industry specific risk - These are the factors that influence all the companies in a particular industry. This includes the regulatory framework. Cyclicality of revenues. The competition in the sector. A look at the woes of the telecom sector would make you understand how industry risks can hurt the profitability of even the best of companies.
  3. Market risk - No company operates in isolation. Factors like interest rates, inflation, government changes, etc. are always at play. These factors directly and indirectly affect the operations of all companies. For example the depressed macroeconomic scenario of the country has had an adverse impact on the profitability of nearly all companies. Companies have seen margins come under pressure. Most companies are finding growth tough during such times. These factors constitute what is called the market risk.
Having understood the components of risk, the next question is how does one reduce the risk in their investments. An important thing to understand here is that risk cannot be completely eliminated. Even the long term government bonds have some amount of risk inherent in them. Nevertheless, risk can be contained.

One way of managing risk is by having the right asset allocation. While we are no experts at wealth management we have always stressed on the need to have cash and gold in your portfolios. This acts as a safety net particularly when the times are bad. In addition to this even for equities we suggest that you do not put too much money in a single stock or sector. That is why we advise our subscribers to have a well-diversified equity portfolio comprising the appropriate proportion of small cap, mid cap and large cap/ blue-chip stocks. Based on their relative riskiness, we have created an asset allocation pyramid that can help you in deciding how much money you should invest in a stock. However, it must be noted that the allocation levels could differ from person to person depending on the risk appetite.

Another way of managing the risk is by having a checklist in place. This lists out all the key variables that influence all stocks. The list includes parameters related to the company's financial performance, the industry in which it operates as well as its management quality and financial strength. This checklist can be used as a reference point for analyzing any stock.

To conclude there are several risks that are inherent in investing. The best way in which investors can manage and reduce these risks is by first understanding all the possible ways in which they can lose money. Once you know this, then you can work out intelligent ways to eliminate or reduce these possibilities. The beauty of investing is that each market in which we invest gives us the opportunities that can be exploited to manage risk. What we need to do is to do our homework on these opportunities so that we can identify and deal with them. Once we know how to deal with it, then risk no longer remains a scary word.

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