How to Evaluate Risk Through Choppy Waters
In my previous write-up, I put the spotlight on my dear friend from whom I learned priceless values and skills. This time, in this space, I’d like to draw a technical picture to make the process of decision-making simpler.?
?We make several decisions in our day-to-day life. Some decisions are made intuitively, some are taken impulsively, while others are often well-planned. One of the most important factors to consider in these decisions is risk.?
?In the dynamic world of business, every decision comes with its own set of risks. The decision you make today, may in some way or the other affect the future. One fundamental concept that plays a pivotal role in risk assessment is the Formula of Total Risk, which can be expressed as Total Risk = Systematic Risk + Unsystematic Risk.?
?Systematic risk is the one that largely impacts the entire market and is driven by factors that are not in our control - e.g. a natural calamity or a war between nations that causes spikes in crude price etc.?
?Unsystematic risk is identified as one associated with a particular company or its business. It’s majorly confined to their operations - for e.g. workers of a company going on a strike or a major fire breakout impacting production and more.
Apart from Systematic Risk and Unsystematic Risk, the investment decisions that we take largely depend on our conduct. And quite often, we fail to notice them because of our unawareness or inexperience, thereby turning them into a larger risk on our portfolio. Some of the prominent types of risks are –?
?We all encountered Systematic Risk during the COVID-19 Lockdown in 2020. It was one of the worst and sharpest falls in history. Something similar happened in 2008 in a different fashion whereby the price points dropped dramatically in a few months.?
?“Fear Psychosis'' – the “Herd Mindset of the World is going to end” refrains us from adding to the portfolio. Such a mindset makes us anxious and we call an exit. Some may not exit on account of Indecision (scroll down to learn more), while only a handful may think of adding during these times.
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?First, let’s understand what equity investment is. We are in a marketplace where greed and fear are traded. Some make a lot of money at the cost of the others. This is the very basis of a marketplace. Literally, the best of the Banking Stocks, for e.g. Axis Bank, IDFC Bank, ICICI Bank and so on, have gone up by 300-400% since the pandemic, in just 3+ years delivering over 100% CAGR. So, in such cases, don’t let fear take control of your actions. Hand over the steering to greed. Yes, you heard that right!
?During such market conditions, my advice is - ‘Instead of adapting to the Herd Mindset of Fear, reform to the Rare Mindset of Greed’. This ideology may multiply your investments even if the world comes to end.?
?2.???Value Risk
?Exactly opposite to Herd Behaviour Risk is Value Risk. When everyone starts buying equities of a particular company, prices start going up by 4-5% on an average. During such situations, most of us end up buying stocks of companies we know little about. Just making purchases on an impulse may cost you a bomb in the long run. The last thing you should be doing is not knowing the real value of the goods you are buying. Therefore, before investing, it’s important to know about the financial performance and future roadmaps of companies.?
?Don’t pay over the top just because the world is going after it. When we do so, some smart people are going to eat away our money. Remember, it’s a marketplace where one is buying and the other one is smartly selling.
?3.?? Indecision Risk
?This is one of the most common risks. Generally, we hold stocks for a very long period, relying on nothing but hope. At times, we get lucky when they pay off, but sometimes they go against our decision and we lose more value, and then there are times they give us nothing at all. Hence, when your equity investment has taken more than adequate time and it’s not delivering the desired results, you must consider taking a closer look identifying the real reasons for continuing to hold them. Don’t just hold them because you are not sure what to do, or because the easiest decision turns out to be indecision. Why should you act, when you don’t need that capital so desperately. Perhaps you don’t not need it at the moment, however, the purpose of growing your investment goes for a toss and that’s a big risk. So, indecision is one of the biggest risks that we quite often carry with us.
?All in all, we must view the Formula of Total Risk as a guide, not a limitation. Managing both systematic and unsystematic risk is a delicate balancing act. By leveraging market insights and strategic foresight, we can mitigate the impact of systematic risks. Simultaneously, by fostering a culture of adaptability, innovation, and prudent decision-making, we can effectively reduce unsystematic risks.
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