Understanding Stock Market Risk and the Tools to Hedge it
An Acceler8now.com Investing Education Resource July, 2007
Let's get this straight: risk is a part of life and risk-taking is positive in many ways. Not to take any risk (if that were even possible), will perhaps be the biggest tragedy in a man's life. Why? Because that life is unlikely to accomplish anything. "The man who goes the farthest is generally the one who is willing to do and dare" - Dale Carnegie (1888 - 1955). Smart investing simply means you've learnt to deal with the risk in managing your investments. So, agreed, we don't detest risk, right?
It was necessary to clear that point. Having said that, it's important too to mention that investment risk is a fairly complicated subject for a beginner-discuss as this one. So, we will concentrate on key aspects and leave the fine points. What then is stock market risk and how does this relate to investment risk? Stock market risk is merely looking at investment risk from the stock market perspective. Generally, investment risk refers to the risk that the value of your investment will diminish on account of factors affecting the market. When you invest in stocks, even with the best of stock selection analysis, there is no guarantee that factors you didn't foresee or factor in would not crop up and adversely affect the value of the stock, depressing it and causing you a loss. That's the risk. You could also see it as the variability in your expected returns - that likelihood that you will not earn the returns you project for your investment. Either way, you are looking at the prospect of falling short in your investment value expectation.
Risk Classes
Just to explain this further, let's examine the nature of the risks that can affect your investment. Two broad risk classifications need to be understood:
- Systemic Risk:
This refers to the risk that is inherent in the market itself. Risks in this class affect the entire market and cannot easily be diversified out through portfolio construction. They include those inflicted by inflation, interest rate movements, exchange rate fluctuation, political dynamics, a general depression, market crash, regulatory changes, etc. They are induced by macro factors.
- Non-systemic Risk:
This one is perculiar to a stock or particular industry sector. This includes business risk which impinges on earnings, financial risk due to leverage and liquidity risk dealing with the marketability of the stock. Risks in this class can be largely managed through portfolio diversification.
All this matters simply because you must deal with risk to emerge a successful investor. Besides, risk can undermine your success in two major ways: overlook or underestimate it (aggressive?) and you possibly burn your fingers; overestimate and overly dread it (conservative?) and you probably will watch big opportunities roll by. Your best bet: continue to research the subject to master it and learn to literally pull the nuts out of the fire. Constructive engagement is the spirit. Having said this, what are some of the techniques and strategies or principles to apply?
Strategies for Risk Containment
It cannot be exhaustive here, but the following should hold you in good stead:
- Pursue Risk Diversification
You got it, this should be dealing with the un-systemic risk. Portfolio theory is a large subject but the bottomline is that you can reduce investment risk by building a portfolio (basket) of investments that contains a mixed class of assets. For instance: stocks, bonds, real estate, treasury instruments, etc. For stocks, you will be looking at what sectors, what types, what maximum exposure on a single stock, etc. Such assets are however not arbitrarily selected but rather picked with regard to set criteria, including risk correlation - the extent to which they are readily affected by the same risk factors. Uncorrelated or poorly correlated assets make for a diversified portfolio that minimises portfolio risk. The building of this basket, termed portfolio construction, is a careful, deliberate process. It doesn't say you must own every stock or asset type, just what is required to achieve the portfolio quality you desire. In effect, decide what you expect in your portfolio and go ahead to buy.
- Or Try Diversification Through Managed Funds
You can cut all the portfolio-construction headache by simply buying into managed funds - funds that pool resources from investors and spread into assets the fund managers select. Here, experts (hopefully) handle portfolio construction and management and you typically enjoy a diversified portfolio even from a little investment. However, investing in a single fund could be a different risk, since the corporate risk concerns arise.
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Every day I get up and look through the Forbes list of the richest people in America. if I'm not there, I go to work.
Robert Orben, American Writer |
- Research to Buy
Granted that researching stocks requires some skills, is that a justification for buying without any basis for your decision? You strengthen your investment position when you decide to buy stocks on the basis of certain set criteria and to ensure that your investments meet such crietia. Different operators have different strategies, meaning you can't safely just follow, when you don't know what other measures those parties have mapped out. They possibly have pre-planned when to exit, while you stay stuck with the investment only to be hit by a huge loss. Stretch yourself to develop some buy/sell criteria that provide reasonable safeguards for your success and then operate with such rules.
- Get Your Emotions Under control
Common sense stuff. There's some risk involved, you've been told, so be clear-headed about whatever you do. If you can't state a few strong reasons why a particular company is a good investment, should you log in with hard-earned money? The reality, though, is that a lot of our people buy stocks today without knowing any serious thing about the businesses they are investing in. It's all a ban-wagon action: buying because there is some frenzy about a particular stock, which, for all you know, might have been engineered. If the security of your investment is important to you, you won't join a frenzy unless your evaluation justifies it and you won't regret the outcome of not joining, even if you lost a chance to make quick gains.
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