How many times we have seen our investment gains going up and giving us a pleasant surprise. We take it in our stride. Some of us take it as our excellent stock picking abilities while some are more humble and think this is all because of market as a rising tide raises all boats. Similarly, how many times we have seen a stock that has gained enormously in last couple of months has started downward slide for no apparent reason. This is the most frustrating experience. Again some of us blame the market while some are more humble and learn from the experience.

Let me give you an example here. I invested some amount in Hanung toys, a soft toy making company. In about 8 months, the stock went up 3 times, a whopping 200% gain in 8 months. I was expecting it to go up more because the PE ratio and other fundamentals still looked fantastic. Suddenly the stock started losing its value and lost 50% from there in a span of 30 days. This was bad. Certainly, it is not right to judge a company in 1-2 years when you are there for long term but this example is just to show the fluctuation in the stock market. Yes, we have all heard about it and in fact seen it too. But experiencing it is altogether a different thing.

 

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Risk Reward Concept

I am sure many of us have faced such situations. All of us invest in market (I am assuming people who come to this blog do invest or at least plan to invest in the market). Some invest after looking at financials, some by looking at chart, some by reading SMS hot tips or uncle’s tip, some just by looking at stars (I always wonder about the cosmic nature of stock prices). What we miss very often is the concept of risk and reward which almost never fails in practice. The risk reward concept may seem to fail in short term but it always works in the long term.

The definition of risk is often misunderstood. Risk in market term means variability of returns. To cite one example, if a stock’s price went up by 100% in 6 months and came down by 90% in next 6 months, the stock will be called highly risky. The measure of risk is standard deviation.

Equity and equity oriented mutual funds entail the highest risk in all investment assets. The returns are high but also volatile. Corporate Bonds, on the other hand, generally give consistent returns over time and hence considered less risky. Government bonds always give consistent returns and hence they the least risky assets.

How to manage investing risk

Now that we know risk is something all investors are exposed to, we would rather discuss the ways to manage the risk. Managing risk requires some work from our side, apart from reading tips, charts, and even financial statements. There is certainly sound merit in understanding business, financials, and annual reports but if you do not understand your risk profile, all of them will not help you.

Let’s look at some of the action items we should take up to manage the investing risk better and limit our losses.

Understand why you are in the market

You should have an objective in mind, a reasonable financial goal. I use the word “reasonable” to convey that you should not have overly optimistic expectation from the market. There were times in technology boom era when people expected to double their money every year. This is unrealistic. You would only lose more and deceive yourself by having such financial goals.

A reasonable goal could be that you need money for your MBA education after 5 years of job. You will need 20 lakhs for your education in 5 years and you can invest Rs 15,000 per month now from your salary.

Understand when you need to meet your goal

As already explained in the first point, you should set the timeline and follow that. There will be times when you are enjoying the bull ride in the market and you are tempted to get some more returns in another year. That another year never comes.

Understand the products that meet your objective and the risk associated

You need to know what investment products are available in the market and what should you expect from these products. Understanding the volatility of returns of the investment products will help you set the expectation right. For example, it is reasonable to expect 15% to 20% returns from index fund in over a period of time but you should also know that the index is built on equity which is riskiest of all the investment assets.

Risk and Rewards of various investment products

Market is full of investment assets. The variety of products today is mind boggling. We will not focus on exotic products but mainly equity, bond, and money market. Let’s take a look at the typical returns from these products and the risk associated with them.

 

Investing assets

Average returns

Associated Risk

Equity & Equity Mutual Funds

15%-25%

High

Balanced mutual funds (equity and debt combined)

8%-15%

Medium

High rating corporate bonds

8%-12%

Low

Government Bonds, PPF, NSC, Post Office

6%-10%

None

Saving account, FD, deposits

3%-9%

None

 

I know my profile, so where should I invest

Now the most logical question at this point is where you should invest if you know your risk profile. For convenience, we will divide investors in three main categories and see what kinds of products are suitable for them.

High risk takers:

These investors are pretty aggressive and can take high risk. Especially young people who just entered the job have disposable money and they also have time on their side. They can take higher risk than someone who has crossed his or her 40. Investors who can take risk should look for equity and equity oriented mutual funds. These are high risk high reward investments. However, to gain from this strategy, investors must have a long term plan for their investment. If your time horizon is less than 5 years, don’t invest in equity alone but substitute some bonds too.

The inherent risk associated with equity and equity oriented mutual funds is the impact of overall market movement. When the whole market crashes, your investment will come down despite your company being excellent and underpriced.

Medium risk takers:

I think most of us fall into this. Though we rarely behave like investors under this category. We often behave like high risk takers and mess up our financial situation.

Medium risk takes can invest in balanced funds which invest in equity as well as bonds or pure corporate bonds. The consistency in the return of bonds provides stability to overall portfolio. Bonds usually do not entail any risk except inflation and interest rate risk which are quite unpredictable. Moreover, even the balanced funds have a part of their fund invested in equity and hence open to market fluctuation. The risk is certainly reduced but not eliminated.

Risk-averse investors or conservative investors

They do not want to take risk. I would not suggest being like them unless you already have lot of money. While being conservative may give you average returns and does not let you lose money, it also keeps you away from some of the good time where you can make money. I am not suggesting that you should not be like a conservative investor. It is entirely individual decision that everyone should take for himself or herself by looking at the risk appetite.

The investment options available for conservative investors are Government bonds, PPF, FD, even high grade corporate bonds, and other Government sponsored bonds. Recently announced Infrastructure bond that gives you tax benefit could be one such investment.

There is absolutely no risk except the inflation and interest risk.


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