- Date : 19/06/2020
- Read: 6 mins
Nobody can guarantee a trouble-free stock market, but there are measures to cushion any blows and even nullify them.
Remember the market rally in the days immediately after Finance Mister Nirmala Sitharaman tabled her budget proposals on February 1? It ended the week by about 4% higher. Stocks were doing well, investors were happy, but the upbeat mood did not last long as general sentiments dampened again after concerns over coronavirus resurfaced.
RBI Governor Shaktikanta Das tried to lift spirits saying the outbreak would not impact us much, though everyone looked for another source of succour – easing up of trade tensions between the US and China. Basically, uncertainty set in within days of the post-budget market buoyancy, and it was the global market that dictated domestic market trends rather than any significant developments on the local front.
What’s more, small investors were left fretting over their stock holdings and wondering how they were going to deal with such uncertainties.
Related: A beginner’s guide to capital markets
Risk management
Actually, it’s a common reaction among retail investors across the world when local indices, such as our Nifty 500 and the Sensex, take a knock. At such times, small investors inevitably start to get nervous about the prices of the stock they own.
However, such worries and tensions can be avoided if they follow the rules of risk management. In stock market parlance, risk management refers to the art of identifying and assessing potential risks to an investment and developing strategies to counter those risks.
Nobody can guarantee trouble-free days at the bourses; there will be volatility, there will be losses – but one can try to cushion the blow; even avert them as much as possible. Effective management of risks surrounding your portfolio ensures that if you have entered the stock market with the sole aim of income generation, you’re simply managing a portfolio.
But if it is to achieve a particular goal – either long-term or short-term – you need to manage risk accordingly. Funnily enough, it is this risk management that is often overlooked as a key element in investing.
Understanding the goals
So how does an investor go about managing market risks for their portfolio of equities, securities, and debentures? For this, it is essential to understand the purpose of making money from an investment, the projected time frame to reach that goal, and the investor’s risk appetite.
For very long-term (15+ years) goals such as building a retirement corpus, you can take much greater risks as you have more time to take corrective measures. Such goals also have the potential of generating more long-term returns.
On the other hand, if you need to accumulate a fund quickly for a down payment on a house or an offspring’s marriage, the time frame would likely be shorter (3–5years). For this, two conditions are needed: lower market volatility (which cannot be guaranteed), and lower risk exposure (which can be attempted).
While no portfolio is entirely risk-free, there are several ways in which investors can manage these risks. As the late celebrated US investor Benjamin Graham used to say, successful investing is about managing risks, not avoiding them.
Related: How do the Stock Split and Stock Merge work?
Managing risks
So, keeping Graham’s advice in mind, let us explore some ways in which risks can be managed:
- Portfolio diversification
Remember the saying we were taught as a kid: Never place all your eggs in one basket? This advice is somewhat akin to that – a useful risk management strategy in the stock market, whereby you spread your investments among multiple companies, sectors, and asset classes in a portfolio. This way, you diversify your risks in that portfolio. This strategy seeks to reap optimal advantage from the fact that rarely do the market values of all investments decrease at the same time; while some fall, others will rise. Mutual fund investments too yield the same results.
- Tilt avoidance
A mid-cap company is usually characterised by low trading volumes and higher sensitivity to news, positive or negative. This means that while the attention on them is less (because of low trade), the news sensitivity ensures the potential gain (and loss) is higher for them as well. So, while chasing goals quicker, you might be tempted to invest more in mid-cap stocks in pursuit of higher returns at a faster pace. This imbalance could cause your portfolio to run greater risks. You need to guard against this; a few bigger companies in your portfolio should help.
- Stop-loss technique
This is a mechanism (an instruction to the broker) to stop trade on behalf of the investor in case a stock price hits a certain predetermined level. Sometimes also called a stop order, it helps investors limit their losses in a position during unfavourable market conditions.
Related: 5 Signals to watch out for a stock market crash
The stress test
The methods suggested so far – anticipating and side-stepping risks or reducing their impact – involve more of taking decisions at the human level. There is also a fintech solution for this, called stress-testing. This computer-simulated technique helps investors analyse how an investment portfolio is likely to perform in adverse economic scenarios.
A stress test can help investors estimate the risks to their investments, the adequacy of assets, and also help them assess what internal processes and controls can be set up to meet these risks. Incidentally, such tests have been made mandatory for banks in the US in a bid to manage their capital and risk.
Last words
Do bear in mind that, ultimately, every action you take in the stock market will have a fallout – even if you play it safe. If your attention is wholly focused on avoiding risks, for instance, it would also mean you’re limiting your gains. At the same time, do not get carried away with taking risks; it is advisable to cap your losses to at a fixed percentage of your capital invested.
Let us assume you have Rs 1 lakh in equity capital. Your strategy should be to expose not more than 10% of it to a risky punt. A loss of Rs 10,000 can be covered, but any more than that can be a real problem. This way, you’re taking limited risks to chase high returns; but if you fail, you know when to call it quits – before the losses balloon to an unmanageable magnitude.
Come to think of it, this too is a risk management strategy!
If you think you need more clarity regarding the stock market, take a look at some of the important things you need to know before investing in the stock market.
Remember the market rally in the days immediately after Finance Mister Nirmala Sitharaman tabled her budget proposals on February 1? It ended the week by about 4% higher. Stocks were doing well, investors were happy, but the upbeat mood did not last long as general sentiments dampened again after concerns over coronavirus resurfaced.
RBI Governor Shaktikanta Das tried to lift spirits saying the outbreak would not impact us much, though everyone looked for another source of succour – easing up of trade tensions between the US and China. Basically, uncertainty set in within days of the post-budget market buoyancy, and it was the global market that dictated domestic market trends rather than any significant developments on the local front.
What’s more, small investors were left fretting over their stock holdings and wondering how they were going to deal with such uncertainties.
Related: A beginner’s guide to capital markets
Risk management
Actually, it’s a common reaction among retail investors across the world when local indices, such as our Nifty 500 and the Sensex, take a knock. At such times, small investors inevitably start to get nervous about the prices of the stock they own.
However, such worries and tensions can be avoided if they follow the rules of risk management. In stock market parlance, risk management refers to the art of identifying and assessing potential risks to an investment and developing strategies to counter those risks.
Nobody can guarantee trouble-free days at the bourses; there will be volatility, there will be losses – but one can try to cushion the blow; even avert them as much as possible. Effective management of risks surrounding your portfolio ensures that if you have entered the stock market with the sole aim of income generation, you’re simply managing a portfolio.
But if it is to achieve a particular goal – either long-term or short-term – you need to manage risk accordingly. Funnily enough, it is this risk management that is often overlooked as a key element in investing.
Understanding the goals
So how does an investor go about managing market risks for their portfolio of equities, securities, and debentures? For this, it is essential to understand the purpose of making money from an investment, the projected time frame to reach that goal, and the investor’s risk appetite.
For very long-term (15+ years) goals such as building a retirement corpus, you can take much greater risks as you have more time to take corrective measures. Such goals also have the potential of generating more long-term returns.
On the other hand, if you need to accumulate a fund quickly for a down payment on a house or an offspring’s marriage, the time frame would likely be shorter (3–5years). For this, two conditions are needed: lower market volatility (which cannot be guaranteed), and lower risk exposure (which can be attempted).
While no portfolio is entirely risk-free, there are several ways in which investors can manage these risks. As the late celebrated US investor Benjamin Graham used to say, successful investing is about managing risks, not avoiding them.
Related: How do the Stock Split and Stock Merge work?
Managing risks
So, keeping Graham’s advice in mind, let us explore some ways in which risks can be managed:
- Portfolio diversification
Remember the saying we were taught as a kid: Never place all your eggs in one basket? This advice is somewhat akin to that – a useful risk management strategy in the stock market, whereby you spread your investments among multiple companies, sectors, and asset classes in a portfolio. This way, you diversify your risks in that portfolio. This strategy seeks to reap optimal advantage from the fact that rarely do the market values of all investments decrease at the same time; while some fall, others will rise. Mutual fund investments too yield the same results.
- Tilt avoidance
A mid-cap company is usually characterised by low trading volumes and higher sensitivity to news, positive or negative. This means that while the attention on them is less (because of low trade), the news sensitivity ensures the potential gain (and loss) is higher for them as well. So, while chasing goals quicker, you might be tempted to invest more in mid-cap stocks in pursuit of higher returns at a faster pace. This imbalance could cause your portfolio to run greater risks. You need to guard against this; a few bigger companies in your portfolio should help.
- Stop-loss technique
This is a mechanism (an instruction to the broker) to stop trade on behalf of the investor in case a stock price hits a certain predetermined level. Sometimes also called a stop order, it helps investors limit their losses in a position during unfavourable market conditions.
Related: 5 Signals to watch out for a stock market crash
The stress test
The methods suggested so far – anticipating and side-stepping risks or reducing their impact – involve more of taking decisions at the human level. There is also a fintech solution for this, called stress-testing. This computer-simulated technique helps investors analyse how an investment portfolio is likely to perform in adverse economic scenarios.
A stress test can help investors estimate the risks to their investments, the adequacy of assets, and also help them assess what internal processes and controls can be set up to meet these risks. Incidentally, such tests have been made mandatory for banks in the US in a bid to manage their capital and risk.
Last words
Do bear in mind that, ultimately, every action you take in the stock market will have a fallout – even if you play it safe. If your attention is wholly focused on avoiding risks, for instance, it would also mean you’re limiting your gains. At the same time, do not get carried away with taking risks; it is advisable to cap your losses to at a fixed percentage of your capital invested.
Let us assume you have Rs 1 lakh in equity capital. Your strategy should be to expose not more than 10% of it to a risky punt. A loss of Rs 10,000 can be covered, but any more than that can be a real problem. This way, you’re taking limited risks to chase high returns; but if you fail, you know when to call it quits – before the losses balloon to an unmanageable magnitude.
Come to think of it, this too is a risk management strategy!
If you think you need more clarity regarding the stock market, take a look at some of the important things you need to know before investing in the stock market.
