How do stock market investors manage risk?

What is risk? How should investors manage risk? Here’s a primer for newbies and experienced investors.

stock market

Risk hai toh ishq hai (take risks to make the most of life) – goes the famous line from the popular TV series Scam 1992: The Harshad Mehta Story. This seems to have become the anthem of many young (and some not so young) investors in the equity market.

These investors many a time are mistaking their gambling instinct for their risk tolerance. They flirt with equity stocks in the anticipation of getting some quick gratification; and not surprisingly, often end with substantial losses. These investors should rather spend some quality time understanding the risk in investing and marry the risk by imbibing it in their investment plan and strategy.

Inadequate understanding of risk

I did a quick survey of household investors’ perceptions of risk, their methods of managing risk. The survey told me that risk may actually be one of the least understood, though most talked about, terms amongst investors. A significant number of such investors appear to be carrying serious misconceptions about the risks involved in investing activities, especially equity investing.

Most of the investors seem to be believing that volatility in the market price of securities is the only risk in investing. They are either oblivious of other risks or tend to ignore them as immaterial.

The following two observations from the survey are particularly noteworthy.

– Buying Options is perceived least risky

“I take calculated risk in the market. I only buy options. The loss in options is limited while the gains are unlimited.”

This is the most noteworthy comment from the survey. This implies that people may be buying naked options, fully knowing that they can lose 100 percent of their principal amount if the option expires out of money by the end of the week/month. They are “investing” inequities, just the way they would buy a lottery ticket – risking 100 percent of their capital if the final outcome does not match their wager; sincerely believing that they are taking “minimal risk”.

– Volatility of markets is perceived as the most important risk

The most seasoned participant in the survey said, “I invest only in quality companies. There is no risk in such investments. The only risk is market price volatility, which I can easily take since I invest for long term.

Almost every respondent in the survey believed that volatility in the market price of shares and market manipulation are the most important risks in equity investments. A significant proportion of the respondent believed that volatility is the only risk, and they did not mind taking it.

Besides the market volatility risk, market manipulation risk appears to be the most popular risk factor amongst investors. Most of the respondents sounded convinced that so-called operators are able to manipulate the prices of stocks “at will”. Some of them even sounded sceptical, believing that the over-regulation of market functioning is actually helping these operators. A significant proportion of investors strongly believed that the market volatility is staged by operators to deceive the gullible small investors, implying that market volatility is mostly an integral part of the market manipulation exercise of the unscrupulous elements.

Only a tiny percentage of respondents mentioned the business risk (company-specific) as a major risk element in equity investing. About two-thirds of the respondents were not aware that companies like Aban Offshore, Suzlon, JP Associates, Jet Airways, OBC, SCI, Unitech, BHEL etc. were part of the benchmark Nifty 50 index in 2007, and hence prima facie qualified to be included in “quality portfolios”. Most investment gurus and revered fund managers owned some of these names during 2007-2016.

… whereas business risk may have spiked higher

Increased global competition, accelerated technology evolution, and transformative regulatory changes, have led to a tremendous rise in business risk. More mid and large-sized businesses face the risk of redundancy and obsolesce today, than ever. This risk was mostly associated with the smaller and weaker businesses in previous decades.

The pandemic has in fact enhanced the business risk in numerous businesses like transportation, hospitality etc. The commitment to climate change may itself threatened the sustainability of many businesses that rely on conventional fuels and technologies.

Diversification is the best tool to manage risk

One of the key observations of this survey was the inadequate awareness of the participants regarding the concept of diversification. Most participants responded by saying that diversification means spreading the capital over a larger number of instruments, e.g., stocks, mutual fund schemes, etc. A diversified mutual fund scheme was invariably accepted as adequate portfolio diversification.

In investing parlance, diversification is actually a three-layered process. At the top layer lies an asset allocation plan that incorporates assets that are mostly uncorrelated to each other in their risk-return profile, e.g., equity, debt, deposits, precious metals, commodities, real estate etc. The middle layer relates to the systemic diversification within various uncorrelated asset classes based on geography, form, security etc., e.g., developed vs emerging equity; corporate vs sovereign debt; hard vs soft commodities; paper vs physical gold; urban vs rural real estate, direct equity vs mutual funds, etc. The third level of diversification is buying a variety of instruments within one asset class, e.g., equity shares of different Indian companies, or mutual fund schemes that invest in different sectors or in a diversified portfolio; debt mutual funds that invest in instruments of different risk and maturity profiles; commercial and residential real estate etc.

Buying units in five large-cap diversified equity schemes of different mutual funds, having mostly identical portfolios will not achieve much diversification.

Risk tolerance

The risk management matrix is a function of the personal circumstances of each individual investor. The risk tolerance of an individual, and risk management matrix, is defined by his/her socio-economic status, income stability, health conditions, etc. Since different investors could have very much different loss tolerance, the risk management tools to be used in their individual cases would also be different.

Risk tolerance vs Age of Investor

It is common to associate the risk tolerance of an investor with his age. The almanac of wealth managers specifies that as an investor grows older, his risk tolerance diminishes. In my view, associating the age of an investor with risk tolerance may not be appropriate. In fact, in many cases, the reality may be exactly the opposite.

Take the examples of these two investors:

Investor Mrs Singh is a 75- year old widow. She has 75 percent of her net worth invested in rent yielding good commercial properties. Both her children are well settled in life. She lives in her own house and enjoys good health.

Investor Mr Rajan is a 36- year old Investment Banker. He has a good income, but uncertainties relating to his job are high. He suffers from diabetes and hypertension. He has home loan EMI, auto loan EMI, life insurance premium, and health insurance premiums to pay regularly. He has a 3yr old child who needs to be admitted to a reputable school this year.

Obviously, the risk tolerance of Mrs. Singh is substantially higher than Mr. Rajan. But in reality, Mrs. Singh’s portfolio mainly comprises of bank deposits, debt mutual funds, and FMCG & IT stocks that were purchased good 25-30yrs ago and have grown in value substantially; whereas Mr. Rajan regularly invests in small and midcap stocks with multi-bagger return potential (usually based on the tips he gets during the course of his work); and has a SIP in Nifty ETF (about 30 percent exposure to BFSI sector same as his employment).

Risk tolerance vs asset allocation

It is a common mistake to take a piecemeal view of the asset allocation of investors. Risk management tools are applied only to marketable financial investments, ignoring the other assets and liabilities.

Investor Ms. Bansal has 67 percent of her net worth invested in stocks of her employer bank. She lives with her old and ailing parents in a joint family house. She pays EMI on a car loan she took last year

Investor Mr Mehta has 92 percent of his net worth invested in the equity of his own pharmaceutical business, which is well established and growing at a decent pace. He gets a very good salary and dividends from the company.

Asking Ms. Bansal and Mr. Mehta to make any further investment in equity may not be appropriate in the circumstances.

Asking Ms Bansal to invest in debt funds with high exposure to the financial sector would add material risk to her portfolio. Even making fixed deposits in the bank she works with would add material risk to her portfolio.

Mr Mehta does not need any regular income. He already has a 92 percent allocation to equity. A part of his balance net worth may best be parked in liquid assets that may be converted into cash immediately, should an emergency arise. The rest he can afford to invest – as angel investment, venture capital, or private equity – in the healthcare ventures which he understands the best.

Risk does not mean probability of loss

For most investors, the risk is synonymous with the probability of loss. This misconception primarily originates from the common tendency of not defining the investment objectives.

In a broader sense, risk means the probability of failure in meeting the objective of a plan. In investing parlance, it implies failure to achieve investment goals. The failure may be due to lower than expected returns; loss of capital; and/or lower than expected liquidity.

Focusing on only the safety of capital, usually distorts the entire risk management process. A good risk management plan must address all the three dimensions of the investment objectives of an investor, viz., Safety, Liquidity, and Returns (SLR).

Different investors invest with varying objectives and timeframes in mind. Besides, they may have different temperaments and risk tolerance limits. Those who did not manage the liquidity risk well and were forced to sell at the bottom cycle. Remember, a large number of businesses fail due to liquidity issues rather than business issues.

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