Understanding Risk

What is risk?

Investing in stocks generally involves some level of risk.

Before starting, let’s first understand what we mean by the term ‘risk’. Risk is simply the probability of losing money on an investment. A more technical definition of risk would be the volatility of return on the investment. An asset with erratic returns is considered to be riskier than an asset, whose value stays rather static or moves slowly.

Risk and return

If you want to be a successful stock investor or trader, you need to take some amount of risk.

However, if you don’t want to take a risk, you can keep all your savings into safe investments such as into a savings account but then in the long-run, you may get a low return. Not only this, but inflation might also make your initial deposit less valuable over time.

This is a general instance of a trade-off between risk and return. Less risk means less return and taking more risk, brings the possibility of a higher return.

How much risk should I take?

This depends on various personal factors.

• Tolerance: Ask yourself how much you can bear to lose in one year without giving up on your investment.
• Age: Younger investors are usually more aggressive. It means they can afford to take more risks, considering the amount of time they get as a benefit of investing at an early age.
• Investment goals: If you are saving to buy a house or starting to invest for retirement, you will need to invest in growth stocks. This means taking more risk and getting the best results in less time.
• Time horizon: Before investing, you should have a clear idea of expecting cash in the investment. The longer you can afford to wait, the less risk is involved. Do not invest in risky assets if you may need funds in the short-term.

Types of risk

For higher investment yields, you have to be prepared to take some kind of risk. In particular, you should be aware of three kinds of risk- market risk, industry risk, and unique risk.

• Market risk: Have you ever noticed that the value of individual stocks often tends to move in the same general direction as the overall market index? It is unusual for individual stocks to move markedly against the movement of Nifty Fifty (NSE-50) or BSE-100 or FTSE-100 for that matter. This is because they are all driven by the same factors - inflation, interest rates, and GNP figures that may affect the overall health of the economy. This is known as market risk.

• Industry risk: It is the risk faced by a particular sector, owing to the factors that exclusively affect a particular sector only.

• Unique risk: It is stock-specific. Take, for example, Maruti Suzuki. Its production disruption caused by a strike would be a source of unique risk as in that would only affect Maruti. Other sources of unique risk include error by the company management, new inventions by a competing company, lawsuit, etc.

When you invest in the stock market, you face all these risks. The good news is that you can mitigate a risk by taking a diversified approach towards investment. Diversification means spreading your money over a number of investments in order to reduce unique risks associated with individual investments. The more stocks you add to your portfolio (your collection of individual investments), the more unique risk you will eliminate and the smoother your overall returns would be.