Higher returns entail higher risk. However, taking higher risk does not guarantee higher returns.
In a nutshell:
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One popular piece of wisdom you often get to hear in the stock markets is that higher risk means higher returns. However, we need to qualify this statement. Higher returns entail higher risk; that is correct. However, taking higher risk does not guarantee you higher returns. That means you have to be very careful about the type and quantum of risk that you take when investing in stock markets.
Take risk that you cannot diversify away
This is an interesting point when it comes to equity markets. Essentially, what do we understand by risk? Risk is the likelihood of a bad thing happening or a good thing not happening. We normally measure this risk using standard deviation. The logic is that if a stock is too risky, it is reflected in the volatility of stock performance. However, stock volatility stems from two factors.
Firstly, it could step from stock specific factors like business cycles, bad management, loss of customers, new competition etc. In such cases, you can reduce risk by selling the stock and adding some other stock in your portfolio. The other type of risk impacts all stocks systematically. For example, if interest rates rise or if rupee weakens, then it hits most stocks in a similar way. This is a risk you need to bear since it cannot be diversified away.
Risk management is all about protecting your capital
For any trader or investor, this definition is extremely important. It is said that in equity markets if you take care of the risk, the returns will follow. What does that mean? It means you must set risk limits to your capital. You can have limits on how much you are willing to lose in a single trade, in a single day, in a single stock and how much you are willing to lose on your capital overall. Once these risk limits are defined, the task becomes simpler. You just need to have the discipline to adhere to these rules and cut positions or stop trading when the risk limits are breached.
Risk is also a function of age and financial situation
How much risk you take in the stock markets is a function of risk appetite and risk capacity. Risk appetite is your psychological willingness to take risk. You may have the courage of a sailor, but should you really apply this courage to your trade? That is when we turn to risk capacity.
Risk capacity is a function of your age and financial situation. For example, a person at 28 has more risk capacity as compared to a person who is 45. A 30 year old person with zero debt has higher risk capacity than a person with large outstanding loans. A person who has acquired substantial assets like equity, debentures, property and gold has a much higher risk capacity compared to a person with no assets to his name. All these have a bearing on how much risk you can afford to take in equities.
Understand the risk of not taking risk
This sounds paradoxical but is an important driver for equity investing. If you think that equity, being risky, is not for you, you need to think again. The biggest risk in the financial markets is to not take adequate risk. For example, if you decide to put all your money in a liquid fund, you would probably earn 4% net of taxes. So, it would take 18 years to double your money and that means you hardly accumulate anything over a 20-year period.
On the other hand, if you invest the money in an equity index or equity fund, remember the Sensex has given returns of 390% since inception. That’s an annual growth of over 16%. Even if you assume a more conservative return of just 14%, you double your money in 5 years and grow your money 16-fold over 20 years. That is the kind of returns only equities can provide. Each time you decide to be conservative, remember your biggest risk is not taking adequate risk!
Disclaimer:
Investments in the securities market are subject to market risk; please read all the related documents before investing.
Past performance of an investment asset does not guarantee future returns.
The above article is purely academic in nature and aims to provide knowledge about basic trading concepts & should not be construed as an opinion or advice to invest or trade.