Of late, individual investors have had to deal with all kinds of risks in financial securities. Firstly, falling returns in certain fixed income funds thanks to payment defaults from underlying securities. Then correction in equity markets leading to lower return in equity portfolios. Lastly, the failed lending to real estate developers by individual investors done in consultation with their wealth advisor.
Given that all these events have led to negative returns, one can conclude these are all risky investments. While it is true that there is risk involved in market linked investing, let’s try to distinguish the various types of risks to understand how to manage them better.
The real risk in equity investing is the inability of the underlying company to continue growing its business earnings and profits at a similar rate as before or at a higher rate.
Equity market risk
Price risk in equities is an inherent feature that you should not fear. Prices can be volatile when seen daily or over shorter periods of time; this up and down change in daily prices of stocks and equity indices is driven more by sentiment, demand and supply of the securities on a particular trading day or over a few trading days, rather than any fundamental risk. This kind of volatility can be smoothened out by remaining invested for longer periods to benefit from the fundamental strength of a stock.
The real risk in equity investing is the inability of the underlying company to continue growing its business earnings and profits at a similar rate as before or at a higher rate. If this rate of growth of earnings/profits falls, the market price of the stock is likely to fall as well.
This fall in price and resultant loss to the investor is more permanent in nature (at least until the fortunes of the company turnaround, if at all) and this is what spells risk in equity. You may be able to foresee the situation and sell the stock before it crashes completely or you may choose to sell after the reason for a fall in price is known. By selling the stock, you have removed the risk as well.
Debt market risk
When you invest in debt, directly or via a fund, you are lending to a company which through a bond or debenture promises to pay regular interest on your ‘loan’ and repay principal at a pre-determined date in future. If the company is unable to pay you this interest or the principal, you will not make any return. You may also lose your capital.
Unlike what happens with equity shares, you cannot sell and do away with the risk. You have to bear it, as non-payment of dues cannot be reversed unless you have claims to the assets of the defaulting company. This particular type of risk in debt is known as default risk. The only way to reduce this risk is to be careful who you lend to or double check the quality of the security or fund you invest in.
One way to reduce risk is to diversify across securities and asset classes. Don’t have disproportionate amounts of money in one investment; diversification ensures that if one investment goes bad, you still have others to help you keep your money goals intact. At the same time, adequate research on quality will ensure that performance and default risks are relatively fewer.
If you are working with an advisor, then your first point of research should be around the quality and performance of the advisor. Don’t take the risk of engaging with a poor-quality advisor; the potential financial pain may be the hardest to quantify. While it is true that there is risk involved in market linked investing, let’s try to distinguish the various types of risks to understand how to manage them better.