- Date : 27/06/2020
- Read: 7 mins
Managing risk doesn’t mean avoiding it altogether. Measured diversification of risk can enrich your wealth creation
“No risk no return; go high to get more.” If someone were to give you a 200-rupee note every time they parroted that advice, you would be a billionaire in no time! Clichéd as it may sound, herein lies the fundamental truth in the risk-return interplay. So, if you have an appetite for risk and can withstand volatility, direct equity trading, equity (growth/sectoral) mutual funds, forex, commodity, and derivative trading are the some of the investment product types that you could consider.
When you are seeking investment success, managing risk doesn’t mean avoiding it altogether. Measured diversification of risk brings prospects of higher returns that can enrich your wealth creation. When advancing to riskier investment options, you need to strap-and-buckle with risk management strategies to mitigate losses and minimise the risk of investment.
Here are some strategies to reduce investment risk:
1. Split and strike a balance: Allocating your investment across a mix of asset classes with varying levels of risk-return trade-offs may not guarantee a profit every time, but it reduces the probability of wealth erosion. To efficiently diversify investment, know the risk-return trade-off for the three basic financial market instruments: equity, debt, and money market.
Equity has, relatively, the highest level of risk over the short term due to day-to-day volatility in the market. Equity is reputed to give higher returns too in the long term when fluctuations even out and inflation is beaten.
Subject to less severe short-term price movements, bonds are safer. But in the long term, returns are lower and vulnerable to erosion by inflation. Bond prices are also impacted by interest rate risk – high interest-carrying bonds are sold at a higher price in a low-interest rate regime; the converse is true when interest rates move up.
While regarded the most stable of the three, money market instruments don’t have the potential to beat inflation by a large margin.
Action: Reduce investment risk by balancing your high-risk investments (stock) with medium-risk (bond) and low-risk (money market) options.
2. Divide to thrive: As you diversify investments across asset classes in line with your goals and risk appetite, limit your exposure to a specific type of investment within an asset class. So don’t orient your equity investment to one company or sector. Instead, invest in large-, mid-, and small-cap stocks across high-growth and stable sectors. Also, consider equity or growth and hybrid mutual funds.
Employ diversification to your mutual fund portfolio across fund houses and schemes based on market capitalisation, sector, and theme, according to your risk appetite and goals. Do not diversify at the expense of a concentrated portfolio that focuses on a manageable number of quality investments better for wealth creation, or you could reduce potential gains and end up with a portfolio delivering mediocre results.
Action: Build a diversified portfolio comprising a mix of equity, debt, mutual funds, and other assets such as gold, real estate, and other investment product types such as collectables (art) and antiquities.
3. Pace with the market: Money matters are not a joke, yet comedy and investment have one thing in common: timing is everything! As Warren Buffet once said: “Be fearful when others are greedy and be greedy only when others are fearful”. This means entering when the stock prices are low and exiting when they are high. To deal with volatile market movements, set aside a fixed monthly amount for equity investments. A SIP means you will end up with fewer units for the given high prices in a bull market. Conversely, in a bear market, you will have more, given the lower prices. This way you can minimise investment risk and you won’t end up with overpriced stock that doesn’t fetch returns, and help you book profits in the long term.
Action: Use a SIP for trading in equity or buying equity fund to ride the volatility and fluctuations in the financial market.
4. Set your risk threshold: Determine the extent of the risk you are willing to take on your investments based on your age, conditioning (beliefs, attitudes, money values), knowledge, and experience. If you are young with fewer family responsibilities, you can afford a higher risk appetite. Later in life, as your goals (child education, healthcare, retirement) call for a more stable and steady accumulation of wealth, you may want to reconsider taking aggressive risks. As you turn older, let your portfolio be a reflection of the maturity and wisdom you have gained as an experienced investor
Action: Let your risk appetite determine your approach and choice of products.
5. Beware the temptation to follow the herd: To quote Warren Buffet: “The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd”. In the investing world, it’s easy to get swayed by the next big shiny thing – be it an IPO or NFO. However, step back and evaluate if you have an appetite for the risks that a pro might take in making short-term profits on market upswings.
Think if the glossy returns promised by an investment during an IPO or NFO are realistic, especially when there are no grounds, such as a track record, to determine the suitability of the investment against your risk capacity. A rally in the market is mostly unsustainable and inevitably followed by a market correction, which rationalises the prices of overvalued stocks. So avoid jumping on the bandwagon to buy stock just because it seems a bargain; you could end up stuck with overpriced stock.
Action: Think: if you were to hold an investment for 10 years, will the return beat inflation and be better than gold and real estate? Refrain from knee-jerk investment decisions based on daily news and events.
6. Don’t gamble, research: Successful investors take risks, albeit calculated risk. While it is true that safe and stable investment options such as fixed deposits won’t make you a millionaire, you need to exercise caution while foraying into risky investment avenues. Listen to another Buffetism: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.
While evaluating a stock for investment, study its price movement and the financial health of the company. The rationale is to consider stocks of companies that have a competitive advantage within the industry. Evaluate stocks priced well within the intrinsic value of the company, as they offer a margin to make profits in the long run. Seek reliable advice and guidance from credible financial experts you know.
Action: Review a company’s financials and run a trend analysis of its stock price movements in the backdrop of the industry and market movements. Don’t hesitate to seek professional help.
To ensure your risk management strategies are working, monitor your portfolio periodically. Track the performance and review your portfolio at regular intervals to ensure that the returns are in line with your financial goals. Don’t hesitate to rebalance and further diversify investment by shifting your investments to better-performing products. Similarly, it’s better to sell a poor performer rather than let it weigh you down. However, do not overdo this exercise. Reviewing your portfolio on a daily basis might induce you to get carried away by the emotions and events of the market.
Disclaimer: This article is intended for general information purposes only and should not be construed as investment or legal advice. You should separately obtain independent advice when making decisions in these areas