Risks In Stock Investments

Risk and reward are the two sides of the same coin. So the best strategy of investment is to minimise risk and maximise profit. So let us discuss some of the risks involved in stock investments and strategies to overcome the same.

INVESTMENT RISK 1: BUSINESS RISK 

Business risk is, perhaps, the most familiar and easily understood. It is the potential for loss of value through competition, mismanagement, and financial insolvency. There are a number of industries that are predisposed to higher levels of business risk (think airlines, railroads, steel, etc). For example, some of the low-cost airlines, due to the skyrocketing oil prices, could not withstand the competition. 

INVESTMENT RISK 2: VALUATION RISK 

Now you may find a company you like. The margins are excellent, growth is steady, there is little or no debt on the balance sheet and the brand is expanding into a number of new markets. However, the business is trading at a price that is far in excess of its current and average earnings. It is therefore not possible to justify purchasing the stock. Here it is not the business risk but the valuation risk. This is the risk of investing in overvalued companies. So you need to rephrase the question before investing. “Is the company ABC a good Investment?” The answer may be ‘yes’. But then ask again, “Is the company ABC a good investment at this price?” 

INVESTMENT RISK 3: FORCE OF SALE RISK (LIQUIDITY) 

You have done everything right and found an excellent company that is selling far below than what it is really worth. It’s January and you plan on using the stock to pay your child’s college fees in June. By putting yourself in this position you have bet on when your stock is going to appreciate. This is financially a fatal mistake. The stock market can be relatively certain of what will happen, but not when. For example, take the case of the stock prices of Satyam Computers which tumbled down. Mr. A and Mr. B bought 1000 shares at the rate of Rs 40 per share. But Mr. A had used the money which he had reserved for another important use in the coming few days. The next day the share price of Satyam Computers fell to Rs 13 and even though both of them knew that it was going to recover from this slump Mr. A could not capitalise on the market. But Mr. B could afford to remain in the market. In a month’s time, Satyam Computer’s stock jumped to Rs 59 and Mr. B could make a neat profit. 

MANAGE YOUR RISK 

As an investor you are always forewarned to judiciously single out stocks based on strong fundamentals. Yet, people make mistakes by purchasing stocks that are referred to as hot picks or gainers by word of mouth or through sources on the internet. However, understand the fact that the time lag between the discovery of these value picks and the purchase often factors in whatever arbitrage is available. Consequently, an uninformed investor buys into a stock at its peak and is disappointed on its decline thereafter. However, if one is well convinced regarding the fundamentals and long-term performance of the stock, one mustn’t get swayed by price fluctuations. A strategy to make good gains from such price volatility is referred to as ‘pyramiding’ as in SIP (discussed below). For most investors, it is less risky to invest smaller amounts of money, and add to the investments on a regular basis over time. Th at’s called ‘rupee-cost averaging’ and in general it results in lower cost of investments and higher returns. Let us assume that an investor is convinced about a stock’s long-term prospects and upward trend. In such a situation, every price drop should be mediated as an opportunity to buy into the stock. This will lower the average price of the stock and will consequently imply higher gains for the investor on price recovery. Another strategy is to cumulate additional stocks on every rise. Although this increases the average holding cost of the share, it collates greater holdings at an average price if one is confident about the long-term average trend. This concept emulates the concept wherein more funds are committed from an asset class like debt to equity when the long-term prospects of equity seem positive.
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BETA & RISK 

The beta is a measure of a stock’s price volatility in relation to the rest of the market. In other words, how does the stock’s price move relative to the overall market? To put it briefly, the Beta (B) of a share is a measure which reflects the sensitivity of the return on the security vis-a-vis the market return. The market return is the return you get by investing in the 30 shares which constitute the BSE index. Suppose, there is a share whose Beta is 3. It means that if the market returns increase by 10 per cent then the return from that share will increase by three times i.e 30 per cent. So the share outperforms the 30 BSE shares in the rising market. But what if the market falls? If the market return falls by 10 per cent, this scrip’s fall will also be three times sharp i.e 30 per cent. Can you assess that high Beta means that the share is very volatile, i.e more risky? Beta seems to be a great way to measure the risk of any stock. If you look at young, technology stocks, they will always carry high betas. Many utilities, on the other hand, carry Betas below 1. If, during the bull phase of the market, you come across an analysis in an investment magazine (like Dalal Street Investment Journal ) wherein they have given the Beta value of a share, you may invest in that share only if the Beta value is high. But do not buy that share if the overall market sentiment is low. If the Beta value is less than 1, such shares cannot give high returns in a rising market but will add to your confi dence in a falling market. Investors can find the best use of the Beta ratio in short-term decision-making wherein price volatility is important. If you are planning to buy and sell within a short period, Beta is a good measure of risk. However, as a single predictor of risk for a long-term investor, the Beta has too many flaws. Careful consideration of a company’s fundamentals will give you a much better picture of the potential long-term risk.

SYSTEMATIC INVESTMENT PLAN (SIP) 

Everyone is interested to know how we can minimise our risks in investments. In order to minimise the market risk we can always use a systematic investment plan (SIP). What is SIP? It is a simple and time honored investment strategy for accumulation of wealth in a disciplined manner over a long-term period. SIP is an ideal way to invest in equities as it not only allows us to build capital through smaller contributions, but also helps us in tackling the volatility in the market. The plan aims at a better future for its investors as a SIP investor has better protection in the volatile market. If you want to put aside just a small amount regularly, you can plan a SIP as part of your monthly budget. Or, if you have a lump- sum but do not want to invest all of it, using SIP can be a smart move. It helps you to build your portfolio one step at a time and also helps you to ride over market volatility. But above all, you benefit from ‘rupee cost averaging’. If the market goes up, the units you own will increase in value. If it goes down, your next payment will buy more units. Check out the figures for yourself. Look at the following example. Mahesh has Rs 60000 and he plans to invest for a long-term in stocks. On a day when the unit price is Rs 20, he buys 3000 shares. On the other hand, a SIP investor (Manish) accumulates shares in a time-bound manner.

Here you can see the difference. Mahesh’s average price is Rs 20 whereas Manish’s average price is Rs 19. It is obvious that Manish’s strategy has worked out better. As an investor if you don’t have a large amount to invest and also do not want to take much risk on your investment, you should always opt for the SIP option. This will enable you to invest regularly i.e improve investing discipline.