All investments are subject to market risks. We are always advised to read all offer documents carefully before investing. When it comes to investing our savings, everywhere we look, we see that this word “risk” is a pretty big deal. But can you exactly pinpoint what risk actually means? Is it something that is subjective – different for different people or something that is objective, more absolute – the same for everyone? Before you proceed, take a few moments to think about what risk exactly means in concrete terms.

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And welcome back! In the field of finance, experts and academics define the term ‘risk’ as volatility in securities, which is a measure of the amount that securities fluctuate in a given period. But fluctuations, including those on the downside (called ‘drawdowns’) are an inherent characteristic of all securities, especially stocks. If one would like to reap the upside that stocks offer, one has to accept and, in fact, expect that a few of them might fall; even by up to 40% in a short period. This is due to the fact that any underlying business itself is fraught with uncertainty. Moreover, markets are driven by sentiments and fund flows rather than fundamentals in the short run. So, if one wants to invest in stocks, one should be able to sleep peacefully even if there is a significant temporary drawdown in some stocks in the portfolio. There is an assumption here that we do not take loans or invest emergency funds or contingent spends in stocks.

Keeping the above in mind, I have come to realize that risk is not the amount of fluctuation of a security but the chance of a permanent loss of capital. As buyers of stock, we become owners of the business that underlies that stock. We become sleeping partners with the majority owners or managers of that business. Therefore, the risk of permanent loss of capital arises only if the business fails to deliver expected performance or if the stock falls and we decide to book a loss due to some reason. Ultimately, since it is we who decide what businesses to invest in and how much to buy, there is some element of control over the risk that we take through the choices that we make.

Investment is subject to a range of outcomes rather than just a binary ‘success’ or ‘failure’ outcome. Thus, risk is the negative spectrum of the range of outcomes. My job as a money manager is mainly to allocate funds in a way that minimizes this negative spectrum. Of course, I must pick those investment vehicles, where there is a greater chance of a higher upside. But this has to be done while minimizing the risk of permanent loss of capital.

This brings us to another characteristic of risk – the risk of permanent capital loss of a particular investment idea must be seen in comparison with potential reward. For example, bonds are less risky but may give lower returns than equity. Similarly high growth stocks give high rewards but come with higher risk of underperformance. In my investments, I strive constantly to make those investments where there is an asymmetry between risks and rewards. Rewards must be higher, and risks must be much lower. An investment opportunity can be evaluated in terms of risk to reward ratio. A ratio of 1:3 is ideal for me. This means that I look for opportunities wherein if I am expecting a reward of say ₹150, the downside is estimated to be only ₹50.

There is an inverse relation between the time that we remain invested in stocks and risk. The higher this time horizon, the lower the risk of permanent capital loss. This is due to the fact there can be temporary setbacks to business, even if there is good profitability and growth in the longer run. This is why having a longer timeframe of 3-5 years is a significant edge that we, as retail investors, can have over institutional investors. This is also one of the reasons why we must avoid trading on margin and leverage. Such kind of long-term investing can be done effectively only in the spot equity markets and not in futures and options (F&O) contracts.

Lastly, risk is a subjective issue. 40% is not a big drawdown for me and having been in the market for 15+ years, I expect it every once in a while. But seeing even 20% red might be unbearable for someone else. There is no right or wrong, good or bad in this. It is just a part of one’s nature. I still consider myself risk averse because I am more stringent with my capital allocation to only those investments that have an asymmetry between risk and reward. I only invest in those stocks that I can easily analyze and understand. Moreover, the downside in those stocks is most likely capped. I strive to maintain a success ratio of 6+ investment ideas out of 10. If I can minimize my losses, then the overall outcome of the portfolio will be good. In short, I like to play it safe. I encourage my readers to undertake a similar exercise in self-reflection and figure out their own risk bearing capacity and line that up against return expectations. Investment advisors also undertake risk profiling that helps to understand one’s relationship with risk.

Now that we have a deeper understanding of risk as the chance of permanent loss of capital, let us see some ways of mitigating it:

1. Margin of Safety: The principle of prudence is a fundamental approach to investing money. We can choose to invest only in those ideas where the risk to reward ratio is 1:3 or greater. If we estimate the intrinsic value of a share to be ₹50, ideally, we should strive to buy it at a 20% discount. If we find that the expected profit growth of a company is 30% compounded per year, we should discount our estimate by 20%. The exact discount rate is not as important as implementing this attitude in investing.
2. Diversification: We can diversify some of the risk of the portfolio by investing in multiple ideas, so that even if 30-40% of the ideas don’t perform, the rest perform as per expectations. We should be careful that diversification does not become ‘diworsification’. While everyone’s approach is different, I find that 15-20 stocks are more than enough to get the best benefits of diversification. In the long run, overlap of ideas; such as investing in two companies in the same sector, should be avoided. If there will be too many stocks, then even if some move, others may not and drag the overall returns. Moreover, even if one of our portfolio stocks turns out to be a stellar performer, with returns multiple times that of our investment (called a multibagger), it may not move the needle of the entire portfolio for us.
3. Stoploss: Business is very dynamic and subject to many forces that are unpredictable and uncontrollable, such as the macroeconomic cycle, politics and commodity cycles. It is always prudent to cut short losses if the situation with a stock idea has changed. While an absolute stoploss of say 10% is not prudent when investing long term, we should ensure that we are not married to a particular stock or idea. The nature of business and hence investing is such that a prudent investor has to accept being proved wrong. If an idea is not performing for a longer timeframe, it might be better to exit and look out for other opportunities. I completely change my position on an investment if new facts call for doing so. How would you feel and react if you were in such a situation?

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I hope that this brief introduction gives you a better understanding of risk in investing and how to manage it. May you swim and thrive very successfully with the ups and downs in the ocean of investing, without sinking.