Before investing, every investor must first acquire the art of risk management. You see, the stock market is notoriously volatile. Some investors capitalize on the market’s volatility, while others struggle to keep up.
Diversification is frequently recommended as a risk-mitigation strategy for those who are struggling with the stock market’s roller-coaster ride. Is diversification the only solution? The answer is ‘No’.
Diversification can obviously help with risk management, but it is not the only option. Other risk-management tactics and technologies may also be useful.
What tools are we talking about? Let’s look at that in today’s guide. First, let us define risk management.
What is risk management?
To understand risk management, you must first define risk. In the stock market, every rupee of profit in one portfolio equals a loss in another.
When you are positive about a stock, there is someone who is negative about it. Only one point of view will be correct among the two groups of people. Simply put, the stock price might increase or decrease. If one makes a profit, the other will lose. So the risk ratio is 50-50, which is the danger we’re discussing.
As an investor, your goal is to reduce this 50% risk ratio, which we call risk management. This reminds us of a famous quote from the book ‘The Disciplined Trader’: ‘Success is 80% money management and 20% strategy’.
So, skillfully managing both money (capital) and risk is critical to financial success. To manage risk, you must first understand the various sorts of risks that exist. Let’s take a deeper look at the two forms of risk.
Types of Risks
When it comes to investing, there are two basic categories of risks:
- systematic
- unsystematic.
Unsystematic Risk
This is a danger that is unique to a certain firm or investment. To understand unsystematic risk, ask yourself why you believe the stock you acquired will increase in value. It could be because the company has promising prospects, maintains consistent earnings, or has a distinct competitive advantage. If a company has all of these favorable attributes, its stock price is likely to rise, making your investment more valuable.
But here’s the key: just because one company’s stock price is rising doesn’t mean that its competitors or the entire stock market will follow suit. This is what we term unsystematic risk. It is a limited and manageable risk because it is linked to a single firm or investment.
Systematic Risk
On the other hand, systematic risks are occurrences or circumstances that have a simultaneous impact on everything. The COVID-19 crash is a good illustration of systematic risk.
When systematic risks occur, they influence more than one company or industry and can have far-reaching consequences. Systematic dangers are typically beyond our control and cannot be tamed.
So, you see, systematic risk cannot be diversified or controlled. Unsystematic risk, on the other hand, is diversified and manageable. Let’s see how.
Basic Risk Management Techniques
Diversification:
Diversification does not imply investing entirely in a single stock. Assume you have some funds to invest in equities. If you invest everything into one stock, you are taking a huge risk because if that one company fails, you may lose a lot of money.
However, by diversifying your investments, you reduce unsystematic risk. You’ll find that when you add more equities, your risk lowers considerably. This is because, even with a diverse portfolio of companies, there is some risk associated with the overall stock market. We refer to this lingering risk as Systemic Risk. The danger exists regardless of how many stocks you hold.
So, while diversification is an effective risk-reduction strategy, there is always some risk associated with the total stock market.
Hedging:
Hedging acts as a safety blanket for your stocks. The value of your stocks can fluctuate. If you’re afraid about their falling, you can employ hedging.
Here’s how it works. Let’s imagine you believe the price of a stock you own will plummet. Instead of hoping it doesn’t happen, you may take precautions. You buy a put option for that stock. It is similar to betting that the stock price would fall.
If the stock price falls, you profit from the put option, which compensates for the loss in stock value, and you do not have to sell your stocks.
Stop Loss and Targets:
Many investors follow their own risk-management principles. They may limit the amount they invest in a single stock and establish a maximum loss they are willing to tolerate.
If an investment begins to decline, they utilize a’ stop loss’ to limit the loss to a certain percentage of their invested funds. So here you are, shielding the downside.
Second, you must assure profits, so always set an objective. To do this, investors can employ a ‘Good Till Triggered’ (GTT) order. This order type automatically sells a stock when it hits a target price, guaranteeing that profits are locked in.
Advanced Risk Management Techniques
Understanding the Beta of a Stock: Beta indicates how much a stock swings in response to changes in the overall stock market. A stock with a high beta is a bit of a rollercoaster, which means it goes up a lot when the market does, but it may also go down a lot. If it has a low beta, it behaves more like a stable boat. Risk-averse investors should look at equities with low beta, and vice versa.
To better appreciate this, assume you have Stock ‘A’ with a beta of 1.5 and Stock B with a beta of 0.8. If the market rises by 10%, Stock A may rise by 15%, whereas Stock ‘B’ may rise by only 8%. So, understanding beta allows you to estimate how much your stock will fluctuate with the market.
Analyzing a stock’s Value at Risk (VAR) can help manage investment risk effectively. It enables you to identify and plan for probable losses. VAR forecasts the worst-case scenario for your assets by estimating how much you could lose with a particular level of confidence.
For example, if a stock’s VAR is 5% at a given level, it means there is a 5% possibility that your losses will be equal to or more than that amount. In layman’s words, VAR serves as a risk indicator, presenting you with a clear picture of the potential downside. It is an important tool for investors, allowing them to make informed decisions and manage their portfolios more successfully.
To summarize, long-term stock investing can lead to financial gain, but it is critical to manage the inherent risks wisely. Whether you use diversification, hedging, or complex approaches such as beta analysis and VAR, these tactics are intended to protect your cash in the stock market and help you understand the risk you are incurring. Investing always involves risks, so make informed decisions based on your financial status and aspirations.
Frequently Asked Questions (FAQ):
1. What does risk management entail in stock investing?
Risk management in stock investing is recognizing, evaluating, and reducing potential risks in order to safeguard your cash and investment returns.
2. Why is risk management so crucial in stock investing?
Effective risk management reduces losses during market downturns, saves capital, and improves long-term investment returns.
3. What are some popular risk-management measures for stock investments?
Diversification, stop-loss orders, asset allocation, and hedging are common strategies for managing risk in stock investment portfolios.
4. How can I estimate my risk tolerance for stock investments?
Assess your financial objectives, investment schedule, and level of comfort with market swings to assess your risk tolerance and develop an appropriate investment strategy.
5. What role does research and analysis play in managing risk in stock investments?
Conducting extensive research and researching company fundamentals, market trends, and economic indicators can help you make informed investment decisions and effectively reduce risks.
