Equity Markets and types of Risk

We are often told that equity investments are subject to risk. What is this risk? It means earning less than what you expected from a given investment or losing part of what you invested. When it comes to investments we only talk about returns. We do say higher the risk higher will be the return. How easy it would be then to assess a mutual fund if they publish them along with their returns performance, the risks involved in earning such returns.

 

Example

 

For example, a fund gave 25% return by risking and losing your capital to the extent of 5%, and another gave 50% return by taking the risk of losing 100% of your capital. In the absence of risk figures, you would rate the fund that gave 50% return as better than the one that gave the 25% return. However, within the risk parameter, you would prefer a fund that risks 5% of your capital to one that risks 100% of it.

 

Investor mind

 

Investors solicit advice in short tell us what to buy or sell, they say. But we cannot make a significant amount of money if we avoid taking risks. Risk is also an opportunity, but it should be a calculated risk you take. If the fear of losing makes you leave the money idle or put in low-return instruments, then inflation will devalue it. Hence, investment is must, and the risks associated with it must to be understood.

 

In an ideal scenario, the investor should need to take only risks relating to the economy and company performance and our markets are close to achieving this goal.

 

There are several parameters that evaluate the risk factor. Statistical and analytical tools can be used, but they are not affordable for the small investor nor would they always have the time or knowledge to use them. This article lists the parameters that go into risk calculation. Risk can be minimized if we can identify it.

 

Risk is related to time. The first question to ask while making an investment is, When do I need the money? In general, you can take more risk if your investment horizon is distant. This is because you have more time to recoup your potential losses along the way. Major factors that determine risk are stated below.

 

Macro factors that add to risk are the economic performance of the country.

 

  • The GDP growth of 8% + in the last few years has fuelled the stock market rally.

 

  • The Reserve Bank of India controls interest rate movements and each time the Reserve Bank changes the benchmark rates of interest it has a positive or negative impact on the market.

 

  • The dominance of FIIs in India has also led to a sensitivity of the market to interest rate cuts, announced by FED in the US.

 

  • International developments, such as energy prices, WTO, insurgence and wars between countries also impact risk, since such issues affect share prices.

 

  • Regulatory changes such as Truck overloading norms, Intellectual Property Rights, and VAT also add to risk directly if the company is part of such an industry and indirectly, if such changes impact all industries in general.

 

  • The feel-good factor is also necessary to keep the market sentiment buoyant; if everyone feels that the economy is doomed then there is little one can do to improve market sentiment.

Industry-level risks:

 

  • The state of a specific industry, whether it is in growth, maturity or decline phase. Industries such as IP telephones and cell phones are in the growth phase whereas certain type of asbestos sheets manufacturing, which is a health hazard, is not.

 

  • Industry cycles are also important: for example, in the monsoons, there is less demand for cement compared to the rest of the year.

 

  • Structural changes and paradigm shifts in an industry should be observed, such as people’s current preference for motorcycles compared to scooters, or landline phones versus mobile phones or electronic encyclopedias versus printed books.

 

Company-level performance risk:

 

  • Company value sets and governance norms, whether it has a dominant position in the industry financial parameters, such as earning per share (EPS), whether it has short-term or long-term approach to growth.

 

  • Its quality of management and corporate governance are important. Infosys carries one of the lowest risk parameters as far as corporate governance goes since it is one of the best-managed companies in its kind.

 

  • If the company is listed as a Z group share or in Trade-for-Trade settlement, then it is a clear indication that either the company is not fulfilling the listing requirements or there is unusual activity in the market in relation to the share, and the stock exchange has put it under special surveillance.

 

Regulatory risks associated with markets are also important.

 

  • If the quality of regulation is poor then the response to scams is also not adequate. While scams and market manipulation will continue to happen as long as there is human greed, how regulators and the entire legal system respond to them is important.

 

  • Timely prevention, early detection, speedy and severe punishments act will deter potential manipulators. Regular reviews and correction of outdated laws ensure compliance from citizens.

 

Systemic risk relating to stock markets, such as that to do with the technology, needs to be understood. Today, the markets are heavily dependent on complex systems that run through public and private networks; inability to square off an open position during the closure of the market is a major risk.

 

Please read the Risk Disclosure Document that is available with brokers to understand such risks. Successful investing would require you to study prospects and project earnings, P/Es and market prices versus today’s levels, risk /return benchmarks are necessary to review when either is achieved. Avoid greed for more profits or fear of incurring losses. Be rational rather than emotional. Sleep over a decision, if necessary. Haste can make waste.

 

In summary let us remember, No risk No return, No pain No gain.

 

Take small steps, Ask for advice, read books, Use Internet. But don’t give up on investing because a film tells you so or your cousin’s neighbor’s uncle’s co-brothers friend in Jumri Tallaiya said he lost his shirt in the markets! Own your decisions and learn from your mistakes. They are the best teachers!

 

 

Written By:

 

Deena A. Mehta

Managing Director

Asit C. Mehta Investments

Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.

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