Investment Risk
The risks and returns associated with each saving and investment product can be different. The differences include, how readily investors can get their money when they need it, how fast their money will grow, and how safe their money will be. Whether you’re investing with a goal in mind, or saving for retirement, it’s important to understand risk.
Investment Risk
All investments involve some degree of risk. In finance, risk refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision. The investment risk can be defined as the probability or likelihood of occurrence of losses relative to the expected return on any particular investment.
Simply saying, it is a measure of the level of uncertainty of achieving the returns as per the expectations of the investor. It is the extent of unexpected results to be realized.
Risk is an important component in assessment of the prospects of an investment. Most investors while making an investment consider less risk as favourable. The lesser the investment risk, more lucrative is the investment. However, the thumb rule is the higher the risk, the better the return. The smarter way is how you manage the risk to make better returns.
Risk Analysis
Investment involves some level of risk. Understanding the type of risk, or the combination of types of risk, is essential in reducing those risks. Every individual is different, and it’s hard to create a steadfast model applicable to everyone, but here are two important things you should consider when deciding how much risk to take.
Time Horizon
Before you make any investment, you should always determine the amount of time you have to keep your money invested. The riskier an investment is, the greater its volatility or price fluctuations. So, if your time horizon is relatively short, you may be forced to sell your securities at a significant loss. With a longer time horizon, investors have more time to recoup any possible losses and are therefore theoretically more tolerant of higher risks.
Bankroll
Determining the amount of money you can stand to lose is another important factor in figuring out your risk tolerance. This might not be the most optimistic method of investing however, it is the most realistic. By investing only money that you can afford to lose or afford to have tied up for some period, you won’t be pressured to sell off any investments because of panic or liquidity issues. The more money you have, the more risk you are able to take.
Risk Mitigation tools
Your individual investments can typically be summed up in two words: “risk” and “reward.” The general rule of thumb is the greater the potential reward, the greater the risk. But that rule doesn’t always hold true in reverse order greater risk doesn’t necessarily translate into greater potential reward. Sometimes greater risk is just greater risk with little potential reward. Risk isn’t a bad thing. But you need to understand what kind of risks you are willing to take with your investment dollars, and how to reduce unacceptable levels of risk.
You can use several equity risk management strategies. The key ones are
Asset allocation
Appropriate asset allocation refers to the way you weight the investments in your portfolio to try to meet a specific objective and It may be the single most important factor in the success of your portfolio. For example, if your goal is to pursue growth, and you’re willing to take on market risk to reach that goal, you may decide how much portion of your asset should be allocated to stocks or equity and how much to debt. Before you decide how you’ll divide the asset classes in your portfolio, make sure you know your investment timeframe and the possible risks and rewards of each asset class. Different asset classes offer varying levels of potential return and market risk.
Portfolio diversification
Asset allocation and portfolio diversification go hand in hand.
A well-diversified portfolio, based on the tenets of Modern Portfolio Theory (MPT), is the classic method of minimizing portfolio risk. The logic behind diversification is sound, if you hold assets that behave differently in different market environments, then some investments should become more valuable when others become less valuable thus helping to insulate the portfolio from major drawdowns.
While a well-diversified portfolio can be a good first step toward managing some investment risks, it might not always be enough for protect-stage investors nearing a goal. Diversification’s most notable flaw for protect-stage investors is that it requires future relationships (such as correlation, covariance, distribution of returns) between different investment categories to be both known and stable. Unfortunately, those future relationships are simply unknowable.
Rupee-cost averaging
Rupee-cost averaging is a disciplined investment strategy that can help smooth out the effects of market fluctuations in your portfolio.
With this approach, you apply a specific amount toward the purchase of stocks, bonds and/or mutual funds on a regular basis. As a result, you purchase more shares when prices are low and fewer shares when prices are high. Over time, the average cost of your shares will usually be lower than the average price of those shares. And because this strategy is systematic, it can help you avoid making emotional investment decisions.
Using stop-losses
A stop-loss order authorizes your broker to automatically sell a stock when it falls to a specific level. This is the lowest price that the investor is willing to sell and prevent further loss. Setting a stop-loss point is useful when the market does not move as per the investor expectations. This protects you from excessive losses during sharp market corrections. It also checks your tendency to sit on a loss-making stock for too long in the hope that it rebounds.
Adding non-cyclicals to the portfolio
These are stocks of companies that sell essential goods and, as such, are relatively insulated from economic cycles. Examples include pharmaceutical and Fast-Moving Consumer Goods (FMCG) stocks. This is because people cannot stop spending on healthcare and groceries, irrespective of the state of the economy. At best, they may reduce their spending on some essential goods and services. As such, non-cyclical stocks have relatively stable revenues, which translate into stable stock prices. You may find many experts call them ‘Defensives’.
Hedging
Hedging refers to the use of derivative instruments, such as Futures and Options contracts, for risk management in equity. A futures contract helps you to fix the price for a future buy/sell transaction in the future. This way, you can cut down the risk of price fluctuations. For example, even if the price of your stock falls, you can sell it at the higher price that you fixed. Similarly, you can buy at lower rates even if the price rises thanks to derivatives contracts. There are different types of such derivatives contracts that you can use.
Investing in dividend-paying stocks
Companies that have a history of consistent dividend payments are usually strong, established companies. Adding them to your portfolio can shield you from equity risk.
Companies are generally reluctant to cut their dividends because the market perceives a dividend cut as a sign of poor financial health. As such, dividend-paying stocks also ensure that you receive a constant stream of returns, even if their prices fall. They reduce risk by bringing more predictability and stability to your portfolio.
Pairs trading
This is a good way to mitigate investment risk when you are anticipating a big price move, but are not sure of its direction. An example is when a big regulatory decision is expected to be made, but you don’t know what the decision will be. In such cases, you simultaneously buy the stock of one company and short sell (i.e. sell first and cover by buying later) the stocks of another company from the same sector. Ensure that both stocks are not related and are likely to benefit in different ways. This ensures that irrespective of which stock rises or falls, you profit.
Conclusion
While there’s no shortage of risk reduction strategy and methods, they’re not all created equal. By understanding what works and what doesn’t when it comes to manage your portfolio risk, you can take steps to determine if your current approach to risk mitigation is doing all it should or if it’s time to consider using a new approach that will maximize your ability to grow and protect your wealth and enjoy the experience along the way.
Ranjith
Dilzer Consultants Pvt Ltd
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