How to reduce the risk of your portfolio and increase returns?
It doesn't matter what kind of security you buy there is always some risk inherited. You may not always get the anticipated returns. and sometimes you’ll make more profit than expected but remember that things can go downhill as well. For every rupee of profit, you make there is a person on the other side losing that rupee. which is basically if there is a group of investors making money, then there must be another group of investors losing money and usually, this group making money is small. so, managing risk is an essential part of investing. We hope that this article will you to identify risk and reduce it!
what exactly is a risk?
In financial terms risk basically defined as the probability of losing money the money which you invested. Stock market is an uncertain place so everyone is exposed to some sort of risk based on the risk tolerance which is basically how much of money the person is willing to lose. Of course! none is willing to lose money but the risk is inherited though.
The riskier the stock is the more return it produces and it should compensate for taking on that risk. when we say the stock is volatile, the price of stock changes in big numbers relative to the overall market. The volatility of stock when compared to the stock market is known as beta(you'll know more about it as you proceed). A stock with low beta vale is volatile i.e overall change in the market has less impact on the stock that the stock with high beta. Risk varies for different securities, for example, government bonds are considered to be less risky than stocks.
There is one more thing that is used to measure risk and it is something called the standard deviation. It is a measure of how much the stock price swings high and low compared to its average price. A low-risk stock will experience small changes and therefore be more predictable but a risky stock is unpredictable and has larger changes in stock price.
What are the types of investment risk?
As you learned about risk, now you should know the types of risks involved in investing. Well, there are two major types of risk.
Unsystematic risk or diversifiable risk is something that is inherited risk and affects a certain company or even an entire sector. Let's imagine you buy stocks of a company A for Rs.100000. and later some time due to some reasons like the management didn't perform well, the company was overvalued and the stock price reduced drastically, such reasons might affect your investment and that's unsystematic risk i.e, specific to a company. so, you can choose to invest in 2 different companies to reduce risk. But sometimes the entire sector might be affected due to some factors. For example, mine workers go on strike. If you hold stocks only stock from the mining industry, then you would face high unsystematic risk so, if you have invested in many stocks in the sector you might make a loss.
You can actually reduce the unsystematic risk by diversifying your investments. which is basically buying stock from different sectors and asset classes. This leads us to a very important question – how many stocks should a good portfolio have so that the unsystematic risk is completely diversified. Take a look at the graph
Systematic risk or non-diversifiable risk is something that affects the overall market, stocks form all sectors get affected and the systematic risk can't be diversified or avoided. Factors such as inflation, interest rate, geopolitics, and monetary policies of the central bank are the cause of systematic risk. Let's assume that you own a well-diversified portfolio of 20 stocks, a recession will affect all the 20 stocks and the overall stock market, another example is the financial crisis of 2008. so, the systematic risk can't really be diversified, unlike unsystematic risk. but instead, you could minimize the systematic risk by hedging or investing in a different asset class such as bonds, real estates, and commodities.
All securities out there carry some risk with them. Identifying potential risks and minimizing the risk in the best possible way is risk management. By minimizing the risk you could increase your return on investment.
Here are the few things with which you can minimize the risk and increase your returns but you can't completely eliminate risk.
As you learned earlier beta is the measure of the volatility of a stock or a portfolio, compared to the overall stock market. Beta basically tells us how much the stock will be affected when there is a bear market or when the stock market is volatile and vice versa. For example, if the beta of a stock is 1, then the stock is said to be volatile and there will be a huge change in stock price when the stock market is volatile(i.e more UPs and DOWNs) and if the beta of stock less than 1, then the stock is considered to be less volatile i.e there will be less change in stock price when compared to the stock market and during high market volatility.
Beta has some disadvantages like, you can only know the short term risk of owning the stock because the risk of owning the stock may increase or decrease in the future depending on the performance and growth of the company and beta makes little sense for an investor who is focused on the long term.
Assets like gold have a negative beta, which means gold is less volatile, compared to the overall stock market and in fact, that's why gold price increase during high stock market volatility. So you can have gold in your portfolio to reduce the risk of your portfolio.
here is how you can calculate the beta!
Margin Of Safety
The margin of safety is basically finding a wonderful stock(in terms of financial strength) and buying it when it is undervalued(below intrinsic value) and hence you'll have reduced the risk of owning the stock. The margin of safety concept was introduced by an American Investor Benjamin Graham, he is considered as the father of value investing. so, how do you say that the stock is undervalued or when is the stock undervalued? well..that's saved for another article. Stay tuned to the Walth blog.
Asset Allocation And Diversification
Investing a single stock or a single asset class is risky especially when the business doesn't perform well or during the times of crisis, investment losses it's value and you might make a loss. Individual stock is highly volatile so spreading out your investments, which is basically diversification reduces risk.
diversification is investing in a different asset class such as stocks, bonds, real estate, and ETFs based on your risk tolerance and financial goals. You can further diversify your portfolio by selecting a mix of securities within each asset class. For example, there are different types of Securities classified by geographical locations, industry, and sectors. It reduces the unsystematic risk and overall volatility of the portfolio.
Investing is one of the great ways to build wealth and risk management is one of the must-have skills. With proper risk management, you will be able to minimize risk and increase your returns.