Risks Associated with Direct Equity Investing
Risks Associated with Direct Equity Investing
One of the top most questions that comes in each and every investor’s mind is among investing in mutual fund scheme or direct equity, what should he or she opt for?
Let’s try to answer this question in this article.
An equity mutual fund comprises a basket of stocks actively managed by a professional fund manager. However, it is very important for you to understand the fact that investment in a single stock is not equivalent to that of investing in a mutual fund. In fact, you can say investing in a basket of stocks can be comparable to investing in mutual funds.
Before we start comparing investing in direct equity stocks and mutual funds, one important thing to remember is that both investment avenues have a risk element. However, mutual funds are considered less risky compared with investment in stocks. Mutual funds provide you with diversification across stocks and sectors. This ensures that you risk is well-spread. When it comes to direct stocks, you might face certain limitations simply because you may not have the required research or familiarity with certain companies or sectors.
Mutual funds are a passive investment for the investor, which are actively managed by a professional fund manager. However, direct equity investment requires active management from the investor. From a cost of investment perspective, investing in stocks works out cheaper than investing in mutual funds. The brokerage that you pay when you buy a stock is much lesser than the fund management fees that you would pay while investing in a mutual fund.
Direct equity investment is well-suited to investors who have skills and knowledge to pick stocks. Moreover, these investors will often tend to have access to stock market research and data, which will help in taking stock calls. More importantly, investors in direct equity must ensure that they have the time to manage their equity investments on a daily basis.
Most first time investors or people who are not familiar with the stock markets generally prefer mutual funds. That said, irrespective of whether you want to invest in mutual funds or direct equity stocks, you can always appoint a professional stock broking agency. Some of the major benefits of having a professional broker handle your investment include proper financial planning, diversification strategy, timely stock market tips, recommendations, advisory, research, and much more.
Types of risk associated with equity investments
We so often hear about investments in equity being a risky proposition. Before investing in any of the product one should have enough knowledge on the financial instrument. Investing in equity comes with risks. Have you ever wondered what these risks are? And what are the factors affecting your investment decision in the instrument? Risk is nothing but the deviation from expected returns. Higher the risk, higher the returns and vis-versa. So, risk and return are said to be inversely related. Likewise investing in equities comes with the higher risk while investing in bonds are considered to low risky and expected return are also less.
Here are different types of risk associated with investment, which you need to be carefully throughout your investment.
The country’s economy plays a vital role in performance of financial instruments. The economic risk includes growth of the country, inflation, interest rates, balance of payment etc. Any hindrance in any of the sector will directly impact the financial status of the country.
This will have direct impact on the company performance, indirectly hitting your shares and your money. So, one has to keep eye on the economy and developments.
Exchange Rate Risk
Most of the companies revenue is dependent from outside country especially software and import-export companies who are mainlydependent on the exchange rate. Any fluctuations in currency will direct impact the company profit and shares. So, people with such exposure can enter into futures and option where they can minimize their losses by hedging.
It is also very important that how the company manages its finances. The company’s equity-debt ratio. How the company prefers to borrow money? If the company is highly leveraged than there are chances of not meeting liabilities and can go bankrupt. Before investing any shares, do look at all the possible ratios which could impact your investment.
Industry level Risk
All industries face cyclical growth. So, one should examine the previous performance of the industry to know whether the company is in growth phase of decline phase and invest accordingly. Any new industry specific news will also hamper the stocks of the company. Apart from these there are other risks like management risk, business risk, and interest rate risk. Most of the investment risk can be reduced by being update and the best way is diversifying your stocks into different sectors.
Breaking down Private Equity
Private equity investment comes primarily from institutional investors and accredited investors, who can dedicate substantial sums of money for extended time periods. In most cases, considerably long holding periods are often required for private equity investments in order to ensure a turnaround for distressed companies or to enable liquidity events such as an initial public offering (IPO) or a sale to a public company.
Private equity offers several advantages to companies and start-ups. It is favoured by companies because it allows them access to liquidity as an alternative to conventional financial mechanisms, such as high interest bank loans or listing on public markets. Certain forms of private equity, such as venture capital, also finance ideas and early stage companies. In the case of companies that are de-listed, private equity financing can help such companies attempt unorthodox growth strategies away from the glare of public markets. Otherwise, the pressure of quarterly earnings dramatically reduces the timeframe available to senior management to turn a company around or experiment with new ways to cut losses or make money.
Private equity comes with its own unique riders.
First, it can be difficult to liquidate holdings in private equity because, unlike public markets, a readymade order book that matches buyers with sellers is not available. A firm has to undertake a search for a buyer in order to make a sale of its investment or company. Second, pricing of shares for a company in private equity is determined through negotiations between buyers and sellers and not by market forces, as is generally the case for publicly-listed companies. Third, the rights of private equity shareholders are generally decided on a case-by-case basis through negotiations instead of a broad governance framework that typically dictates rights for their counterparts in public markets.
While private equity has garnered mainstream spotlight only in the last three decades, tactics used in the industry have been honed since the beginning of last century. Banking magnate JP Morgan is said to have conducted the first leveraged buyout of Carnegie Steel
Corporation, then among the largest producers of steel in the country, for $480 million in 1901. He merged it with other large steel companies of that time, such as Federal Steel Company and National Tube, to create United States Steel – the world’s biggest company. It had a market capitalization of $1.4 billion. However, the Glass Steagall Act of 1933 put an end to such mega-consolidations engineered by banks.
Private equity firms mostly remained on the side-lines of the financial ecosystem after World War II until the 1970s, when venture capital began bankrolling America’s technological revolution. Today’s technology behemoths, including Apple and Intel, got the necessary funds to scale their business from the Valley’s emerging venture capital ecosystem at the time of their founding. During the 1970s and 1980s, private equity firms became a popular avenue for struggling companies to raise funds away from public markets. Their deals generated headlines and scandals. With greater awareness of the industry, the amount of capital available for funds also multiplied and the size of an average transaction in private equity increased.
Risks of investing in shares
The biggest risk of investing in shares is that you could lose some or all of your money. It’s important not to trick yourself into thinking that this couldn’t happen to you.
Worse still, a company could go out of business and you could lose everything that you invested in it.
When you make investments, you should have realistic expectations about how they might grow and what you might achieve as a result.
Set the bar unrealistically high and you’ll need to take on more risk and open yourself up to higher potential losses.
Questions to ask yourself
How much can you afford to lose?
The price of shares will go up and down so think seriously about how much money you could tolerate losing without it impacting your lifestyle.
Will investing keep you up at night?
Think about how you would feel if the value of your share portfolio fell by 10%, 20%, 30% or 50%. You should set this range for yourself and find the right balance of investments to match your capacity for losses.
How long do you have to invest?
Your tolerance for risk is always linked to the length of time you have to invest. The longer you have to invest, you more able you will be to withstand the ups and downs of share markets. If you are trying to make short term gains, you will be more vulnerable to short term losses.
Can you afford to not have access to your money?
If there’s a chance that you’re going to need to access your money in the next year or two, shares are probably not for you. If the share market unexpectedly goes down in that time, will you be able to wait for a recovery?
Risks faced by equity funds
Market risk is basically a risk which may result in losses for any investor due to a poor performance of the market. There are a lot of factors which affect the market. A few examples are a natural disaster, inflation, recession, political unrest, fluctuation of interest rates. Market risk is also known as systematic risk. Diversifying a person’s portfolio won’t help in these scenarios. The only thing which the investor can do is wait for the storm to calm.
Concentration generally means focusing on one thing. Concentrating a huge amount of a person’s investment in one particular scheme is not a good option. Profits will be huge if lucky, but losses will be more. Best way to minimize this risk is by diversifying your portfolio.
Concentrating and investing heavily in one sector is also very risky. The more diverse the portfolio, the lesser the risk is.
Interest Rate Risk
Interest rate changes depending upon the credit available with lenders and the demand from borrowers. They are inversely related to each other. Increase in the interest rates during the investment period may result in a reduction of the price of securities
For example, an individual decides to invest Rs 100 with a rate of 5% for a period of x years. If the interest rate changes due to changes in the economy and it became 6%, the individual will no longer be able to get back the Rs 100 he invested owing to the fact that the rate is fixed.
The only option here is reducing the market value of the bond. If the interest rate reduces to 4% on the other hand, the investor can sell it at a price above the invested amount.
Liquidity risk refers to the difficulty to redeem an investment without incurring a loss in the value of the instrument. It can also occur when a seller is unable to find a buyer for the security.
In mutual funds, like ELSS, the lock-in period may result in liquidity risk. Nothing can be done during the lock-in period. In yet another case, Exchange traded funds (ETFs) might suffer from liquidity risk. As you may know, ETFs can be bought and sold on the stock exchange like shares.
Sometimes due to lack of buyers in the market, you might be unable to redeem your investments when you need them the most. The best way to avoid this is to have a very diverse portfolio and making fund selection diligently.
Credit risk basically means that the issuer of the scheme is unable to pay what was promised as interest. Usually, agencies which handle investments are rated by rating agencies on this criteria. So, a person will always see that a firm with a high rating will pay less and vice-versa.
Mutual Funds, particularly debt funds, also suffer from credit risk. In debt funds, the fund manager has to incorporate only investment-grade
securities. But sometimes it might happen that to earn higher returns, the fund manager may include lower credit-rated securities.
This would increase the credit risk of the portfolio. Before investing in a debt fund, have a look at the credit ratings of the portfolio composition.
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