Till now we have discussed how to evaluate companies in equity based on their financial statements. If you have not seen that post you can read about it here. In this post, we are going to see what is risk and how investors can manage risk.
What is Risk?
In finance, risk refers to the degree of uncertainty and the potential financial loss inherent in an investment decision. It is the chance that an outcome or investment’s actual gains will differ from the expected outcome or return. In other words, risk includes the possibility of losing some or all of the original investment.
One common metric associated with risk is standard deviation. Standard deviation measures the volatility of asset prices compared to their historical averages within a given time frame. A high standard deviation indicates greater value volatility and, consequently, higher risk.
Remember, understanding risk is crucial for investors and business managers to make informed decisions and manage their portfolios effectively.
What is Risk Management?
Risk management is the systematic process of identifying, assessing, and mitigating threats or uncertainties that can impact an entity. So let’s understand one by one what these terms mean.
Identification: It involves recognizing potential risks. These risks can be related to various factors such as economic changes, technology, environment, or competition.
Assessment: Once identified, risks are evaluated regarding their likelihood and impact. Understanding how likely a risk is to occur and how severe its consequences could be helps investors prioritize their response.
Mitigation: Strategies are developed to minimize harm caused by risks. These strategies may involve preventive measures, contingency plans, or risk transfer (such as insurance).
Monitoring: Investors continuously monitor the effectiveness of their risk management measures. Adjustments are made as needed to ensure ongoing protection.
All of the above are the general steps involved in risk management, which can be used by investors or companies alike.
For example, from an investor’s perspective, an investor must first identify what are the types of risks involved while investing in a particular asset class or asset macroeconomic shifts, cyclical business model, etc. Then the investors need to assess the risk and whether it suits their risk appetite based on the frequency of occurrence and projected downside. Then they can take steps to mitigate the risk by hedging, diversification, or taking some other measures. And then the final step would be to monitor if the investment is performing as expected and if the risk is in check.
Effective risk management is crucial for generating expected returns and more importantly, estimating a fair return with incorporating risks involved in the deal.
Companies use risk management to maintain stakeholder confidence, achieve better business outcomes, and promote growth. High-performing businesses recognize the importance of strategic risk management and actively work to avoid reputational, financial, or strategic failures.
Risk Management techniques
Some of the common and intuitive risk management techniques are described below:
Avoidance: This strategy aims to eliminate or bypass risks altogether. If a risk is too severe, avoiding it might be the best approach.
Retention: Accepting the risk and handling it internally. Sometimes, retaining a risk is more cost-effective than transferring it.
Transferring: Shifting the risk to another party. Examples include insurance or outsourcing.
Sharing: Collaborating with others to manage risk. Partnerships, joint ventures, and consortiums fall under this category.
Loss Reduction: Implementing measures to reduce the impact of a risk.
For investors particularly there are two things that the investors can do which are discussed later in the post. But before this, we need to understand two important terms.
Alpha and Beta
Next, let us understand two of the important terms associated with investment for investors.
Alpha:
Alpha represents the excess return on an investment after adjusting for market-related volatility and random fluctuations. A positive alpha indicates that the investment outperformed its expected return based on market risk. If a stock or fund delivers a return higher than what its beta predicts, that extra return is attributed to alpha. Investors seek positive alpha as it suggests skillful management or unique insights.
For example, if someone invested in the equity markets for 10 years and the market indexes have returned a CAGR of 15% and the investor has been able to generate a CAGR of 18% on his equity markets then he/she has generated an alpha of 3% on his/her investments in equity market.
Kindly note that the returns have to be compared in the same market as the benchmark.
Beta:
For investors, risk is generally evaluated by a metric called standard deviation. It is calculated as the square root of the variance. The variance measures how much individual data points deviate from the mean, and the standard deviation provides a more intuitive understanding of this variability or volatility of things.
Smaller values of standard deviation indicate that the data points cluster closer to the mean, suggesting relatively consistent values, meaning less volatility.
In investing the standard deviation is called Beta and it measures the volatility relative to a benchmark, often the Nifty 50. So this comes under a quantitative way of assessing risk.
- Beta of 1: Moves in line with the benchmark.
- Beta > 1: More volatile than the benchmark.
- Beta < 1: Less volatile than the benchmark.
For example, a stock with a beta of 1.5 moves 50% more than the benchmark. Beta helps assess systematic risk and diversification potential.
Types of Risk:
Systematic Risk
Also known as non-diversifiable risk or market risk. Arises from macroeconomic factors that affect the entire market or a specific industry. Examples of systematic risk factors include changes in government policies, natural disasters, international economic conditions, and shifts in the overall economy.
It cannot be diversified away because it affects all investments in the same market. Investors can manage this risk through asset allocation or hedging strategies.
Here are some examples of systematic risk events:
- Economic Recession: A widespread economic downturn affecting multiple industries and companies. During a recession, stock markets tend to decline due to reduced consumer spending, business investment, and overall economic activity.
- Interest Rate Changes: Central banks adjusting interest rates can impact bond prices, stock markets, and borrowing costs. Higher rates can reduce corporate profits and slow economic growth.
- Political Instability: Elections, policy changes, or geopolitical tensions can create uncertainty and affect financial markets globally.
- Natural Disasters: Events like earthquakes, hurricanes, or pandemics can disrupt supply chains, production, and economic activity.
- Currency Fluctuations: Changes in exchange rates impact international trade, corporate profits, and investments.
- Commodity Price Volatility: Shifts in oil, gold, or other commodity prices affect industries and economies.
Un Systematic Risk
Also called diversifiable risk or company-specific risk. Originates from internal factors within a specific company or industry. Examples of unsystematic risk include labor strikes, production issues, management decisions, and product-related risks.
It can be reduced through portfolio diversification. By holding a diversified portfolio of assets, investors can minimize the impact of unsystematic risk on their overall returns.
Unsystematic risk, also known as company-specific risk, is the risk associated with a particular investment. Let’s explore some examples of unsystematic risk events:
- Business Risk:
- Internal Risks: These stem from operational inefficiencies within a company. For instance, management fails to secure a patent for a new product, leading to a loss of competitive advantage.
- External Risks: These result from external factors affecting a business. For example, the Food and Drug Administration (FDA) banned a specific drug or food that a company sells.
- Financial Risk: Relates to a company’s capital structure. It includes factors like debt levels, liquidity, and financial stability. For instance, changes in interest rates or regulatory decisions can impact a company’s financial health and stock performance.
Remember, systematic risk affects the entire market, while unsystematic risk is specific to individual companies or industries.
Hedging
Hedging in finance refers to the practice of reducing the risk of adverse price movements by taking an offsetting position in a related asset or financial instrument. It’s like buying insurance for your investments.
Hedging aims to limit potential losses by balancing them with gains from opposite positions. While it reduces risk, it may also reduce potential profits.
Investors use derivatives (like futures, forwards, and options) to hedge. These contracts depend on the value of an underlying asset. If you don’t know what derivatives are you can read about them here. Diversification within the same market by owning both cyclical and countercyclical stocks is another form of hedging.
Remember, hedging involves paying a premium for protection, and it’s a common risk management strategy in financial markets.
Diversification
Diversification refers to spreading investments or business activities across multiple assets or markets. The goal is to minimize risk and increase returns.
Now diversification can be done in two ways:
- Diversification within the same asset class is based on certain characteristics like cyclical and non-cyclical businesses in equity markets, or commercial and residential real estate in the real estate market.
- Diversification across asset classes. Portfolio allocation is a part of this. In this investors invest across asset classes such as equity, real estate, precious metals, commodities, etc. to reduce risk.
This is all for this post. Let me know your thoughts in the comments section. Don’t forget to follow my Facebook and Instagram pages. See you all in the next post. Till then keep learning.