by In stock market there is strong relationship between risk and return. Greater the risk, greater the return generally! In financial terminology risk management is the process of identifying and assessing the risk and then developing strategies to manage and minimize the same while maximizing the returns.
Every investment demands a certain amount of risk and for an investor to assume this risk he has to be compensated duly. This compensation is in the form of something called as the risk premium or simply the premium. Risk is therefore central to stock markets or investing because without risk there can be no gains. Successful investors use stock market risk management strategies to minimize the risk and maximize the gain.
In financial markets there are generally two types of risk; first the Market risk and second the Inflation risk. Market risk results from a possibility in increase or decrease of financial markets. The other risk i.e. the Inflation or the purchasing power risk results from rise and fall of prices of goods and services over time.
The inflation risk is an important consideration in long term investments where as the market risk is more relevant in the short term. It is the market risk that can be managed and controlled to a certain extent, inflation risk cannot be controlled.
There are certain strategies that can be employed to mitigate the risk in a stock market. The strategies are as follows:
- Follow the trend of the market: This is one of the proven methods to minimize risks in a stock market. The problem is that, it is difficult to spot trends in the market and trends change very fast. A market trend may last a single day, a month or a year and again short-term trends operate within long term trends.
- Portfolio Diversification: Another useful risk management strategy in the stock market is to diversify your risk by investing in a portfolio. In a portfolio you diversify your investment to several companies, sectors and asset classes. There is a probability that while the market value of a certain investment decreases that of the other may increase. Mutual Funds are yet another means to diversify the impact.
- Stop Loss: Stop loss or trailing tool is yet another device to check that you don’t lose money should the stock go far a fall. In this strategy the investor has the option of making an exit if a certain stock falls below a certain specified limit. Self-discipline is yet another option employed by some investors to sell when the stock falls below a certain level or when there is a steep fall.
Portfolio diversification
Businesses are susceptible to several uncertainties that adversely affect their stock prices. To protect your portfolio from big losses, invest in multiple stocks. This ensures that even if some of your investments do not perform as expected, the others minimise their effect on the overall portfolio. While diversifying, make sure to invest in stocks that don’t have much in common. Investing in similar stocks exposes you to the same risks and defeats the purpose of diversification. For example, automobile and auto ancillary may seem like different sectors, but they are affected by similar factors. Investing in both these sectors may not help much with risk mitigation.
Remember, diversification does not mean investing equally in all sectors. It means investing in more than one asset or sector.
You can invest more in companies you are more optimistic about. But don’t commit so much that you cannot bear the losses if things go bad.
Using stop-losses
A stop-loss order authorizes your broker to automatically sell a stock when it falls to a specific level. This protects you from excessive losses during sharp market corrections. It also checks your tendency to sit on a loss-making stock for too long in the hope that it rebounds. For example, if you bought a stock for Rs.100 with a stop-loss of Rs.90, your broker will automatically sell the stock when it falls to Rs.90. This can protect you from further losses if the stock falls below Rs.90.
Adding non-cyclical to the portfolio
These are stocks of companies that sell essential goods and, as such, are relatively insulated from economic cycles. Examples include pharmaceutical and Fast-Moving Consumer Goods (FMCG) stocks. Why you wonder? This is because people cannot stop spending on healthcare and groceries, irrespective of the state of the economy. At best, they may reduce their spending on some essential goods and services. As such, non-cyclical stocks have relatively stable revenues, which translate into stable stock prices. You may find many experts call them ‘Defensives’.
Hedging
Hedging refers to the use of derivative instruments, such as Futures and Options contracts, for risk management in equity. A futures contract helps you to fix the price for a future buy/sell transaction in the future. This way, you can cut down the risk of price fluctuations. For example, even if the price of your stock falls, you can sell it at the higher price that you fixed. Similarly, you can buy at lower rates even if the price rises thanks to derivatives contracts. There are different types of such derivatives contracts that you can use. We’ll read about these in depth in the Derivatives section.
Investing in dividend-paying stocks
Companies that have a history of consistent dividend payments are usually strong, established companies. Adding them to your portfolio can shield you from equity risk.
Companies are generally reluctant to cut their dividends because the market perceives a dividend cut as a sign of poor financial health. As such, dividend-paying stocks also ensure that you receive a constant stream of returns, even if their prices fall. They reduce risk by bringing more predictability and stability to your portfolio.
Opting for blue-chips
Not all stocks have the same risk. Stocks of smaller or medium-sized companies can be riskier and more volatile in the stock market. This is because such companies are more prone to various business risks. Established companies, meanwhile, can be more stable. This extends to their stock prices too. So, you can reduce risk by opting for such stocks.
Pairs trading
This is a good way to mitigate equity risk when you are anticipating a big price move, but are not sure of its direction. An example is when a big regulatory decision is expected to be made, but you don’t know what the decision will be. In such cases, you simultaneously buy the stock of one company and short sell (i.e. sell first and cover by buying later) the stocks of another company from the same sector. Ensure that both stocks are not related and are likely to benefit in different ways.
