For those who struggle with the roller-coaster ride of the stock market, experts often recommend diversification as a way to mitigate risk. But is diversification the only solution? The answer is ‘No’.
Diversification can certainly help manage risk to some extent, but it is not the only tool available. Some other strategies and tools can also play a role in risk management.
Which tools are we talking about? Let’s understand that in today’s guide. But before that, let’s understand what risk management truly is.
What is Risk Management?
To understand risk management, you must first understand what risk is. In the stock market, every rupee of profit in one portfolio translates to a loss in another.
When you are optimistic about a stock, there is someone who is pessimistic about it. And from the two sets of people, only one view will be correct. In simple terms, the stock price can either go up or go down.
If one makes a profit, the other would lose. So, the risk ratio is 50-50, and that is the risk we are talking about.As an investor, the goal is to minimise this 50% risk ratio, which we call risk management. This reminds us of a saying from the famous book, ‘The Disciplined Trader’, which goes, ‘Success is 80% money management and 20% strategy’.
So, effectively managing both money (capital) and risk is the key to achieving financial success. To manage risk, you need first to understand the different types of risks that exist. Let’s take a closer look at these two types of risk.
Types of Risks
There are two main types of risks when it comes to investing: unsystematic and systematic.
Unsystematic Risk
This is the risk that is specific to an individual company or investment. To understand unsystematic risk, you can ask yourself why you believe the stock you have bought will increase in value.
It could be because the company has great prospects, it is maintaining steady profits, or perhaps it has a unique competitive advantage.
If a company has all these positive qualities, its stock price is likely to go up, which means your investment will also become more valuable.
But here is the key: the rise in the stock price of this company doesn’t necessarily mean that its competitors or the overall stock market will also go up.
This is what we call unsystematic risk. It is a limited and manageable risk because it is tied to a specific company or investment.
Systematic Risk
On the other hand, systematic risks are events or factors that simultaneously impact everything. A classic example of systematic risk is something like the COVID-19 crash.
When systematic risks hit, it affects not just one company or industry but can have a broad impact across the board. Systematic risks are usually beyond our control and can’t be tamed.
So, you see, systematic risk cannot be diversified or tamed. However, unsystematic risk can be diversified and managed. Let’s understand how.
Basic Risk Management Techniques
Diversification
Diversification is not putting all your money into just one stock. Imagine you have some money to invest in stocks. If you put it all into one stock, you are taking a big risk because if that one company does poorly, you could lose a lot.
But, if you spread your money into multiple different stocks, you are lowering your unsystematic risk. And you will notice that when you add more stocks, your risk decreases significantly.
However, after a certain point, adding more and more stocks doesn’t reduce the risk as much but leads to over-diversification.
This is because, even with a bunch of different stocks, there is still some risk that is connected to the entire stock market. We call this remaining risk Systemic Risk. It is the risk that is there, no matter how many different stocks you own.
So, diversification is a smart strategy to reduce your risk, but there is always some level of risk tied to the overall stock market.
Hedging
Hedging is like a safety net for your stocks. When you own stocks, their value can go up or down. If you are concerned about them going down, you can use hedging.
Here is how it works: Let’s say you think a stock you own might drop in price. Instead of just hoping it doesn’t, you can take a protective step. You buy a put option of that stock. It is like betting that the stock’s price will fall.
If the stock price does drop, you make money from the put option, which offsets the loss in your stock’s value, and you don’t have to sell your stocks.
But remember, using options involves risk, so it is important to understand how they work before you use this strategy.
Stop Loss and Targets
Many investors have their own rules to manage risk. They might limit how much they invest in one stock and set a maximum loss they are willing to bear.
If an investment starts going down, they use a ‘stop loss’ to limit the loss to a specific percentage of their invested money. So, here you are, protecting the downside.
Secondly, you must secure profits and hence always set a target. To do this, investors can use a ‘Good Till Triggered’ (GTT) order. This order type automatically sells a stock when it reaches a target price, ensuring it locks in its profits.
Advanced Risk Management Techniques
Understanding the Beta of a Stock
Beta tells you how much that stock tends to move when the whole stock market moves. If a stock has a high beta, it is a bit of a rollercoaster, meaning that it goes up a lot when the market does, but it can drop quite a bit, too. If it has a low beta, it is more like a calm boat. For risk-averse investors, you must look at stocks with low beta and vice versa.
To understand this better, let’s say you have Stock A with a beta of 1.5 and Stock B with a beta of 0.8. If the market goes up by 10%, Stock A might go up by 15%, but Stock B might only go up by 8%. So, understanding beta helps you gauge how much your stock will fluctuate with the market.
Analysing Value at Risk of a Stock
Value at Risk (VAR) is a powerful tool for smart investment risk management. It helps you assess and prepare for potential losses. VAR tells you the worst-case scenario for your investments by predicting how much you could lose within a certain confidence level.
For example, if a stock’s VAR is 5% at a particular level, it means there is a 5% chance that your losses could be equal to or greater than that number.
In simpler terms, VAR acts as a risk gauge, providing you with a clear understanding of the potential downside. It is a crucial tool for investors, helping them make informed decisions and manage their portfolios effectively.
To conclude, long-term stock investing can pave the way for financial growth, but it is essential to navigate the inherent risks effectively. Whether you are using diversification, hedging, or advanced techniques like beta analysis and VAR, these strategies are designed to safeguard your capital in the stock market and understand how much risk you are taking. Investing always carries risks, so make informed decisions aligned with your financial situation and objectives.
Note: The article is for information purposes only. This is not investment advice.
(The author is Vice President of Research, TejiMandi)
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)