Beta – This is the term used by academics to represent risk. In other words, for them volatility is equal to risk. This definition of risk makes sense, if one is a short term trader, but is completely useless for an investor.
In my view risk is multifaceted, fuzzy and grey and it cannot be boiled down to a single number. It is not even possible to minimize all forms of risk at the same time – for example you can minimize the risk of a quotational loss on your portfolio by increasing the cash component, but that increases the risk of missing out on the gains if the market moves upwards.
I am going to break down an investor’s risk in two sections – Risks faced by investor independent of the company/ stock and the business related risks of a specific investment. This post will cover the risks faced by all investors, irrespective of the type of investments.
This is a widely understood form of risk – As one grows older and approaches retirement, the capacity to bear risk reduces. As a 25 year old, one can afford to lose a large portion of one’s portfolio and can still recover from it as one has a long working life ahead. I personally managed to lose almost 25% of my portfolio in my 20s and although it hurt emotionally, it did not make much of a dent on my long term networth.
The duration / cash flow needs
This is usually but not always related to the age of an investor. A younger investor can afford to take a very long term view of his or her investments and think in terms of multiple decades. An investor in his or her late 50s however has several cash flow needs on the horizon such as education for children and hence needs to design the portfolio accordingly. As a result, any capital which is needed in the next 5 years, should not be invested in equities. If you do so, you are exposing yourself to the risk that the market would drop at the time when this invested cash is needed, turning a temporary loss to a permanent one.
A majority of such over confident guys (and they are mostly guys) get their back side kicked and blame everyone else for their failure. A few however are sensible enough to realize their stupidity and work to fix it over time.
This is a rarely discussed risk. Let me explain what I mean by this – One can call this temperament or maturity. There are some people who have temperamentally more suited to the stock market as they are calm, humble and eager to learn. In addition these people do not get swept by greed or fear. As a result such people are able to do fairly well over the long term.
This attitude is however not specific to any age or gender, though I have seen it mostly in men. Women either stay away from financial decisions or if they are forced to manage it, are far more sensible as they realize their limitations.
This is a risk a majority of investors in india face due to the huge amount of misinformation and misguidance by the financial services industry.
The only way to manage this risk is to educate yourself on the basics and never to listen blindly to your friendly broker/ agent whose interest is in the commissions and often not your financial well being.
Quite self explanatory, but a very under-appreciated risk. A lot of people assume that if they invest in fixed income options, they have taken care of their investment needs. My own parents were guilty of this mistake in the past.
I see a lot of educated and young people in my own family ignore this risk to their peril.
Leverage risk is commonly understood as the leverage taken by an investor in his portfolio. I prefer to expand this further and consider all forms of non –investing leverage too. For example, if you have a big home loan and other forms of leverage in the form of personal and car loans, then your flexibility as an investor is greatly reduced.
I have personally looked at leverage in the above manner and worked to ensure that my total debt to networth never exceeds 30-40%. This ensures that my debt servicing is within control and any fluctuations in the stock market, will not force me to liquidate my positions to manage this debt.
I have never seen this risk discussed, but I think it influences your investing behavior a lot. If you have a full time profession (job or a business) which will put food on the table irrespective of how the stock market behaves, it is bound to impact your risk appetite.
It may appear that several of the risks I have pointed out are overlapping in nature. I would agree with that and my post is not provide an exhaustive and non overlapping list of risks faced by an investor. The idea is to look at some risks which are faced by an investor, outside of the specific investment itself.
I have tried to cover risks which are independent of the type of instrument chosen for investing. I think these risks play an important role in determining the nature of one’s investments and the kind of returns one can make. In the next post, I will discuss about the various forms business risks one needs to keep in mind when investing in equities.
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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.
