The parable of the blind men and the elephant aptly describes the understanding of risk among many retail investors. Like a group of blind men, who have never come across an elephant before, each lays a hand on different areas of the elephant’s body, yet is unable to recognize what the animal is.
Risk has many facets to it.
Not everything can be diversified
In 1970, a study by Fisher and Lorie found 95% of diversification benefits can be derived from the construction of a 32-stock portfolio compared to a portfolio comprising the entire New York stock exchange.
Ever since 30 has become the magic number for stock managers. However, it needs to be noted that beyond the sector and stock diversification, there is an element of ‘market risk’ that can never be fully diversified away.
Unlike specific risk, directly linked with an industry or company-based performance, market risk is associated with the overall economy or securities markets.
Also known as systematic risk, it is the risk emanating from unforeseen events such as political instability, terrorist attack and trade embargoes. It is impossible to eliminate all such risks. Prudent portfolio construction, however, could reduce a portfolio’s susceptibility to it.
Risk capacity is different from risk tolerance
Risk capacity is defined as an investor’s financial capability to withstand a financial loss without meaningfully compromising her desired standard of living. It can be measured objectively.
For instance, if an investor has adequate cash savings, pension income and net worth to cover her standard-of-living needs without significantly relying on the value of portfolio assets dedicated to achieving financial goals – then she is said to have a high-risk capacity.
Risk tolerance, in turn, gauges the willingness of investors to take risks and is represented by the maximum amount of uncertainty an investor is willing to accept while taking investment decisions.
As against risk capacity which can be measured objectively, risk tolerance is a behavioural trait determined through questionnaires and tests.
While risk capacity changes throughout the goal timeline, the financial risk tolerance level is relatively stable across time. The former needs to be revisited as the financial situation changes and as one moves closer towards the completion of goals.
Don’t ignore the sub-asset risk
Investors often tend to look at risk only at the asset level. For instance, equity funds as an asset class are considered riskier than debt funds.
However, within equity funds, there is a range of funds – each with its distinct characteristics. Small-cap funds are higher on volatility while large-caps are relatively less so.
While debt funds are relatively safer than equity funds, the NAV of long-term gilt funds can fluctuate a lot based on the interest rates trends in the economy.
So, it is important to look at the risk factors of individual schemes before making investment decisions.
It is all about probabilities
What’s the worst-case scenario for your portfolio over a month? Value at Risk (VAR) gives you a sense of it. It does not express absolute certainty but instead makes a probabilistic estimate.
Just because in the last 40 years, the Indian stock market has not corrected beyond say 30% in a month, doesn’t mean it will not happen in the future. History need not repeat itself.
Risk and return are not always together
Stocks can potentially give a higher return than bonds over the long term but are also more volatile. Bond investors as creditors are legally entitled to fixed amounts of interest and principal. They are repaid in priority if the company goes bankrupt. However, if the company is successful, you won’t earn more than that.
Shareholders in turn are owners. As a shareholder, if the company is unsuccessful, you could lose all your money. But if the company is successful, you could see higher dividends and a rising share price.
Historically, Indian stock market investors have managed to get an annual return of 12% against 6% for bonds – a premium of 6% p.a. for taking higher equity risk. However, this doesn’t always guarantee more returns and in that proportion.
Comprehend risk by understanding its components and by staying away from popular myths attached to it.