A catalogue of risk

Beta – This is the term used by academics to represent risk. In other words, for them volatility is equal to risk. This definition of risk makes sense, if one is a short term trader, but is completely useless for an investor.

I have never used beta or any such silly measures to evaluate risk and as an individual investor could not care less for an academic definition of risk.

In my view risk is multifaceted, fuzzy and grey and it cannot be boiled down to a single number. It is not even possible to minimize all forms of risk at the same time – for example you can minimize the risk of a quotational loss on your portfolio by increasing the cash component, but that increases the risk of missing out on the gains if the market moves upwards.

In a set of posts, i am going to list some of the risks which come to my mind. I will try to explain these risks and give some example too. In the end, I will share a framework which I use to think and make investment decisions.  As always, if you are expecting a magic formulae at the end, you will be disappointed.

I am going to break down an investor’s risk in two sections – Risks faced by investor independent of the company/ stock and the business related risks of a specific investment. This post will cover the risks faced by all investors, irrespective of the type of investments.

Stage of life/ Age risk

This is a widely understood form of risk – As one grows older and approaches retirement, the capacity to bear risk reduces. As a 25 year old, one can afford to lose a large portion of one’s portfolio and can still recover from it as one has a long working life ahead. I personally managed to lose almost 25% of my portfolio in my 20s and although it hurt emotionally, it did not make much of a dent on my long term networth.

I personal think that all kinds of experimentation and trial and error should be done by an investor as early in their working life as possible. However once you cross late 30s or 40s, it is important to focus on risk reduction and avoid losing a large portion of your portfolio (small losses are however inevitable in equity investing)

The duration / cash flow needs

This is usually but not always related to the age of an investor. A younger investor can afford to take a very long term view of his or her investments and think in terms of multiple decades. An investor in his or her late 50s however has several cash flow needs on the horizon such as education for children and hence needs to design the portfolio accordingly. As a result, any capital which is needed in the next 5 years, should not be invested in equities. If you do so, you are exposing yourself to the risk that the market would drop at the time when this invested cash is needed, turning a temporary loss to a permanent one.

The interesting point is that this advantage is usually wasted by the younger investors. I have rarely seen investor in their 20s who are patient and long term oriented. At this stage in life, one usually feels invincible and smart. On top of that if you have graduated from some of the top colleges in the country, you close to 100% sure that you will beat the market in your sleep.

A majority of such over confident guys (and they are mostly guys) get their back side kicked and blame everyone else for their failure. A few however are sensible enough to realize their stupidity and work to fix it over time.

Emotional/ Attitude risk

This is a rarely discussed risk. Let me explain what I mean by this – One can call this temperament or maturity. There are some people who have temperamentally more suited to the stock market as they are calm, humble and eager to learn. In addition these people do not get swept by greed or fear. As a result such people are able to do fairly well over the long term.

On the other hand, you will often find people who are eager to invest in equities but are impatient and bring a level of arrogance to the stock market. They seem to believe that the stock market owes them high returns. As a result a lot of them assume that all they need to do is to buy some random stock touted by a talking head on TV and the money will start rolling in.

This attitude is however not specific to any age or gender, though I have seen it mostly in men. Women either stay away from financial decisions or if they are forced to manage it, are far more sensible as they realize their limitations.

Lack of knowledge + arrogance + greed/ fear is guaranteed recipe for disaster.

Knowledge risk

This is a risk a majority of investors in india face due to the huge amount of misinformation and misguidance by the financial services industry.

A lot of investors have been exposed to the traditional forms of investments such as fixed deposits or gold/ real estate. They are however approached by banks/ brokers and other financial agents from time to time on mutual funds, stocks or insurance and I have personally found that majority of this advice is toxic (see my post here on ULIPs).

The only way to manage this risk is to educate yourself on the basics and never to listen blindly to your friendly broker/ agent whose interest is in the commissions and often not your financial well being.

Inflation/ Cost of living risk

Quite self explanatory, but a very under-appreciated risk. A lot of people assume that if they invest in fixed income options, they have taken care of their investment needs. My own parents were guilty of this mistake in the past.

This risk unfortunately is a very slow and stealthy form of risk where one thinks that his money is growing, but in reality one is falling behind in terms of buying power. This risk comes to bite you at absolutely the wrong time – retirement. At that time, you realize that the nestegg is not sufficient to take care of a lot of your needs. In such cases, in absence of a social safety net, one either has to continue working or depends on others to make ends meet.

I see a lot of educated and young people in my own family ignore this risk to their peril.

Leverage risk

Leverage risk is commonly understood as the leverage taken by an investor in his portfolio. I prefer to expand this further and consider all forms of non –investing leverage too. For example, if you have a big home loan and other forms of leverage in the form of personal and car loans, then your flexibility as an investor is greatly reduced.

Lets say an individual earns around 10 lacs per year and  has around 50 lacs as various forms of loans. This individual is paying around 50% of his earnings as debt repayment. If this individual has around 10-15 lacs as savings, can he or she really afford to invest in a highly volatile small cap fund ? If this was the financial profile of an individual in 2008, he or she would have panicked  and sold all their stocks at the bottom.

I have personally looked at leverage in the above manner and worked to ensure that my total debt to networth never exceeds 30-40%. This ensures that my debt servicing is within control and any fluctuations in the stock market, will not force me to liquidate my positions to manage this debt.

Professional risk

I have never seen this risk discussed, but I think it influences your investing behavior a lot. If you have a full time profession (job or a business) which will put food on the table irrespective of how the stock market behaves, it is bound to impact your risk appetite.

A stable well paying job allows one to take a long term view and invest without worrying about the market volatility. On the other extreme if your monthly expenses depend directly on the stock markets – either from capital gains or through employment as a financial intermediary, then your risk appetite is greatly reduced.

A combination of risk

It may appear that several of the risks I have pointed out are overlapping in nature. I would agree with that and my post is not provide an exhaustive and non overlapping list of risks faced by an investor. The idea is to look at some risks which are faced by an investor, outside of the specific investment itself.

A lot of times, it is the combination of risks which become financially fatal for an individual. Lets say an individual does not save enough early in his or her career, and due to the inflation risk realizes later in life that his nest egg is not going to be sufficient. In absence of sufficient knowledge about various forms of investments, this investor under the influence of a unscrupulous broker may make wrong investment choices. Such an investor can get hurt very badly during a market downturn. I think I may have described the unfortunate situation for a lot of senior citizens.

I have tried to cover risks which are independent of the type of instrument chosen for investing. I think these risks play an important role in determining the nature of one’s investments and the kind of returns one can make. In the next post, I will discuss about the various forms business risks one needs to keep in mind when investing in equities.

I still stand by my post below on managing  non – investing risks

http://valueinvestorindia.blogspot.com/2014/04/shortest-investment-book.html

----------------
Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.