When you invest in any asset class (equity or debt), there is an element of risk. What do we understand by risk? Pose this question to any market player, and the typical answer would be that risk is volatility. There is a subtle difference here. Volatility is not risk; it is the manifestation of risk. When a stock or a bond becomes more risky, it becomes more volatile. Yet, this still does not define risk.
Risk is the probability of a bad event happening or a good event not happening. Thus, risk to an investor in the financial market context refers to the possibility of him/her experiencing losses owing to factors that affect the overall performance of the markets in which he/she is engaged. This implies that risk must be always understood in the context of expectations.
Long story short, greater the expectations (of returns), greater the risk; and lower the expectations, lower the risk.
Let us look at 8 specific kinds of market risks and how to handle them.
Diversify to handle concentration risk
Concentration risk is the risk that you run when you are entirely or substantially invested in one theme or sector. If something goes wrong with the sector, your entire portfolio may go for a toss. The answer to concentration risk is diversification. You don’t have control over how the company performs, but you have control over which stocks/themes you want to be invested in.
Tweak your portfolio to mitigate interest rate risk
Interest risk and inflation risk are related because normally higher inflation leads to higher interest rates. This impacts equities and bonds. When rates are cut, bond prices go up, which improves the NAV of bond funds. Even in case of equities, lower rates discount the future cash flows at a lower rate and boosts valuation. The reverse holds when rates rise. If you are invested in bonds, you can shift maturities and if you are in equities, you need to tweak your exposure to rate-sensitive sectors such as banks, NBFCs, auto, and realty.
Hedge your portfolio against currency risk
You may wonder why currency risk would impact your rupee portfolio. The problem is that the companies that you invest in are vulnerable to currency risk and that spills over to your returns. For example, IT, pharma, and auto ancillaries are essentially export-oriented and benefit from a strong dollar. Sectors such as capital goods, power, and telecom are importers and benefit from a stronger rupee. When you create your portfolio, keep a mix of dollar defensives and rupee defensives to hedge your risk.
Go long-term for getting through volatility times
The bad news is that whether you are invested in bonds or equities, you cannot escape volatility. The good news is that you can manage volatility by taking a long-term and systematic approach. When you play the market as a short-term trader, volatility hits you really hard. From a long-term perspective, volatility in equities tend to even out over time. Further, a systematic or phased approach helps even out volatility.
Stick to low impact-cost names to beat liquidity risk
Liquidity risk arises when you are unable to exit or enter a particular stock within your price range. This problem becomes more profound when the markets become volatile. In a crashing market, liquidity may be hard across all stocks. However, in normal market conditions, you can avoid this risk by sticking to the low impact-cost stocks.
Fight horizon risk arising out of assets-liability mismatch
This is a risk that has nothing to do with market conditions, but more to do with your own investment decision. IL&FS is today in a crisis because it borrowed short-term money and lent to infrastructure projects. This is the best example of horizon risk on a very large scale. If you invest in equities for a goal that is just three years away, you could very well end up in trouble. The answer lies in structuring your investments as per the horizon of your liabilities.
Triumph over reinvestment risk
Let us understand this point by comparing a dividend plan and a growth plan of a mutual fund. A dividend plan pays out dividends and unless you reinvest the dividends at the same yield, you are unlikely to create as much wealth in the long run. A growth plan, on the other hand, just keeps reinvesting the returns. Hence, a growth plan does not have reinvestment risk, while any regular payout in the form of interest or dividends carries reinvestment risk. The solution is quite simple. In mutual funds, you can opt for growth plans and in equities, go for low-dividend and high-growth companies.
In addition, there is also geopolitical risk, which normally gets factored in volatility risk of a stock or the market.
Remember, risks can be many, but a phased, well-informed, and disciplined approach can help you mitigate them to a considerable extent.
As an enthusiast deeply entrenched in the world of finance and investment, I've not only studied the intricacies of various asset classes but have also actively navigated through the dynamic landscape of financial markets. My understanding is not just theoretical; it's grounded in practical experiences and a continuous commitment to staying abreast of market trends.
Now, delving into the concepts discussed in the provided article, the author emphasizes the critical importance of understanding and managing risks associated with investing in different asset classes. Let's break down the key concepts covered:
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Risk and Volatility:
- The article rightly distinguishes between risk and volatility. Volatility is described as the manifestation of risk. When a financial instrument becomes riskier, its volatility increases. However, volatility alone doesn't define risk. Risk, in this context, is defined as the probability of a negative event occurring or a positive event not occurring.
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Expectations and Risk:
- The article asserts that risk should always be considered in the context of expectations. The higher the expectations of returns, the greater the associated risk, and vice versa.
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Types of Market Risks and Mitigation:
- Concentration Risk: Investing heavily in one theme or sector poses concentration risk. Diversification is suggested as a solution to mitigate this risk.
- Interest Rate Risk: Higher inflation often leads to higher interest rates, affecting equities and bonds. Adjusting the portfolio to account for interest rate changes is recommended.
- Currency Risk: Export-oriented and import-oriented companies are impacted differently by currency fluctuations. The suggestion is to hedge against currency risk by maintaining a mix of dollar and rupee defensives in the portfolio.
- Volatility Management: Taking a long-term and systematic approach is advised to manage volatility in both bonds and equities.
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Specific Risks and Strategies:
- Liquidity Risk: Sticking to low impact-cost stocks can help mitigate liquidity risk.
- Horizon Risk: Aligning investments with the time horizon of liabilities is crucial to avoid this risk.
- Reinvestment Risk: Opting for growth plans in mutual funds and choosing low-dividend, high-growth companies in equities can help overcome reinvestment risk.
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Geopolitical Risk:
- Although not explicitly discussed in detail, the article mentions geopolitical risk, which is considered as part of the volatility risk in stocks or the market.
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Mitigating Risks through a Disciplined Approach:
- The article concludes by highlighting that while risks in the market are abundant, a phased, well-informed, and disciplined approach can significantly mitigate them.
In summary, the article provides a comprehensive overview of various market risks and practical strategies to handle them, showcasing a nuanced understanding of the complex dynamics of financial markets.
