Risk Part 1
Warming up to risk
For every rupee earned by one trader, someone else will be making a loss. Consequently, although a select group of traders may gain profit continuously, the vast majority are likely to suffer losses consistently.
Mark Douglas, in his book ‘The Disciplined Trader’, states that a successful trading experience is 80% dependent on money management and 20% strategy. I fully concur with this sentiment. The variance between the two groups is their comprehension of Risk and the methods they employ when managing funds.
Money management and related topics largely involve the assessment of risk. It is, therefore, necessary to understand risk in all its forms. Let us break down this concept to gain a deeper understanding.
When operating in the stock market, risk is understood to be potential monetary loss. Each trade poses exposure to it, regardless of whether or not you are in favour of it. Risk can be divided into two sections: Systemic and Unsystemic Risk. Both are always present when investing in shares.
Think about the potential of financial loss. What, then, can cause a drop in stock prices? Of course, there are many possibilities. Here are just a few:
Deteriorating business prospects
Declining business margins
Competition eating margins
All these signify a form of risk. There might be other causes, and this could continue endlessly. However, a common factor links all of them – they are risks that only affect the company in question. Suppose you have Rs.1,00,000 to invest in HCL Technologies Limited. A few months later, HCL announces reduced earnings and consequently their stock price drops as well. This means your investment reduces value. Nevertheless, this event will not have an effect on the stock price of its rivals like Mindtree or Wipro. Similarly, if any misconduct occurs within HCL’s management, then only they bear the brunt but not their counterparts. These risks are special to just one single company and do not impact others in any manner.
I’m sure some of you will remember the Satyam scam from 7th January 2009; I certainly do. The shocking revelations that Mr Ramalinga Raju disclosed in a letter addressed to stakeholders, investors, clients, employees and exchanges revealed that Satyam Computers had been engaging in fraudulent activities for years. They had created false numbers, mishandled money and misled people – all resulting in an inflated stock price. It took a huge amount of courage for the former Chairman to own up to his wrongdoings despite knowing what repercussions he’d face; credit must be given where it’s due.
Diversification is an effective way to limit the risks posed by unsystemic risk. This involves investing in multiple companies (from different industries), rather than just one. This way, even if one company’s stock price falls due to these risks, your losses are more easily cushioned. For instance, if you invest Rs.50,000/- each in HCL and Karnataka Bank Limited – if HCL faces a decline, only half of your investment is affected. In fact, larger portfolios with many stocks can provide even greater protection against unsystemic risk.
This brings us to an essential query: how many stocks should be in an optimal portfolio in order to fully diversify unsystemic risk? Studies have found that up to 21 stocks offer the necessary level of diversity and any additional investments may not contribute much. My own equity portfolio includes around 15 shares.
As you can see from the graph, when you diversify and add more stocks, the systemic risk decreases substantially. However, after 20 stocks, there is a limit to what can be achieved and the graph begins to plateau. At this point, the residual risk is referred to as a ‘Systemic Risk’.
The risk of all stocks in the markets being impacted by issues such as the macroeconomic climate, governmental policies, geographical conditions and monetary policy is known as systemic risk. This form of risk is caused by a variety of factors that influence share prices and can cause them to decrease significantly. Some examples include:
De-growth in GDP
Interest rate tightening
The list of systemic risk can carry on and on. All stocks, regardless of a well-diversified portfolio with 20 companies, face the same declining stock prices as a result of de-growth in GDP. Systemic risk cannot be diversified – unlike systemic risk – but it can be hedged. Hedging is the method used to rid oneself of such risks, just like an umbrella shields against rain on a stormy day.
When discussing hedging, it is important to understand that it is distinct from diversification. It is easy to see why many investors mistake them for each other, but whereas we diversify in order to reduce systemic risk, we hedge to minimise systemic risk. We cannot forget that no trade or investment can ever be completely secure in the markets; however, through hedging we are able to significantly reduce risks.
Not mine, not yours.
– Expected Return
We will touch on the concept of ‘Expected Return’ before returning to Risk. It is only reasonable to assume that everyone wants a return on any investments. The expected return is quite simple; it is simply the gain you anticipate from an investment. For instance, investing in Infosys with the expectation of a 20% return within one year would make this 20% your expected return.
This is an important concept as it is to be taken into account with various financial calculations; portfolio optimization and estimating equity curves to name a few. We will delve deeper into this topic in the future, but for now, let’s focus on the fundamentals.
In this instance, if you place Rs. 50,000 in Infy (for a year) expecting a 20% return, then the expected return on your investment is 20%. However, what if you divide the sum into half – investing Rs. 25,000/- in Infy and another Rs.25,000/- in Reliance Industries with an anticipated 15% return? What would be the overall expected return in this scenario? Is it 20%, 15%, or something else?
You can deduce that the anticipated return is not 20% or 15%. Since the investments were made in two stocks, this constitutes a portfolio; thus, we can calculate its expected return using a specific formula.
E(RP) = W1R1 + W2R2 + W3R3 + ———– + WnRn
E(RP) = Expected return of the portfolio
W = Weight of investment
R = Expected return of the individual asset
In this instance, Rs. 25,000 is invested in each of the two funds yielding expected returns of 20% and 15%, respectively. Consequently, each investment holds a 50% weighting.
E(RP) = 50% * 20% + 50% * 15%
= 10% + 7.5%
We have tried this approach on two stocks and it can be used across a range of other investments and asset classes. We should note that the anticipated return is not set in stone, but rather an expected return conditioned on probability. The idea has been articulated lucidly by Franco Modigliani in his treatise ‘An introduction to risk and return concepts’.
Now that we are aware of expected returns, let’s move on to explore quantitative concepts such as variance and covariance which will be discussed in the upcoming chapters.