What is risk management
Success in investment lies in how well we manage the risk. To manage the risk, first we should know what are the risk involved in a particular investment asset. While traveling, our objective will be to reach the destination safely and on time. To achieve this, we should ensure that the vehicle we use to travel is in good condition and it is filled with adequate fuel. And as a safety measure, wearing seat belt, carrying adequate food and water, first aid kit is important. Above all, we should have a route map to guide us on the path. Similarly, when we decide to invest, it is vital to know the risk involved and take measures to protect our finance. This process is called risk management.
Risk management entails three steps:
1. Forecasting and identifying the risk
2. Evaluating or assessing the risk
3. Planning measures to overcome or minimize the risk.
Though it is not possible to forecast all the risks in advance, we could identify the possible threats or impacts on our investment. Financial risk can be classified as systematic risk or unsystematic risk. Systematic risk is something that is general and that has impact on overall economy or has global effect. Whereas, unsystematic risk is something that is specific to the company or industry or market. While unsystematic risk can be eliminated or reduced, systematic risk in a portfolio cannot be eliminated as it affects all segments of the market.
To understand the systematic and unsystematic risks, let us go to the example cited at the beginning. The probability of the vehicle running out of fuel or tyre getting punctured are the foreseeable risk which affects our travel but they are all avoidable risk. This type of risk is called unsystematic risk. Whereas, while traveling if there occurs a storm or any other natural disaster, which is out of our control is called systematic risk.
Having understood the difference between systematic risk and unsystematic risk, now let us see some of the possible risk that investment in general is prone to. The various factors that may give rise to risk are:
Company or industry specific risk
Negligence on part of the investor
Among the risk listed above, defaulter risk and company or industry specific risk and negligence on part of the investor are unsystematic risk, and economic, global, natural disasters and political risk are systematic risk which affects all the segments of the economy.
Defaulter risk arises in case of investment in debt instruments. A recent example is of IL&FS Group. The group had defaulted in interest and principle repayment to its investors. When the fiasco came into light, the stock price of all the group companies plunged and many investors were trapped. And, debt mutual funds who had exposure to IL&FS instruments had also taken a hit.
Company or industry specific risk can be understood by the example of Indian pharmaceutical companies. Since the time, US FDA initiated investigation at plants of Indian pharmaceutical companies and issued warning letters, the stocks of major drug manufacturers had taken a toll. Earlier to this, pharma stocks were the multi-baggers and it created wealth to many investors. Still many investors hold these stocks in their portfolio in the hope of a revival. This has dragged down the value of the portfolio of many investors.
Economic risk is the possibility of onset of recession. It is a cyclical one and it is something that is caused due to change in macroeconomic factors such as drastic fall in Gross Domestic Product (GDP) growth, exchange rate, inflation, government regulation etc. This risk impacts all segments of the market and hence it is not possible to be eliminated.
Political risk is the risk caused by political instability in a country. The sudden change in government and political events that change the profitability of businesses affects the value of the investment.
Global risk is present with the globalization of world economies. The economic or geopolitical changes that occur in one part of the world has cascading effect on all the nations. Though we can cite many events that are currently happening around, few examples would be the fear of recession in US, trade war between US and China, Brexit dilemma and change in crude oil prices.
Final and not the least is the negligence on the part of the investor. Many investors either fail to keep track of their investment or fail to act upon a situation due to fear or greed. This is more related to human psychology and this part will be discussed in detail in a separate module. However, an example for this will be the case of Vakrangee Ltd. One of my friend, had bought Vakrangee at Rs.70 and after which the price gradually went up to Rs.512 during January 2018. Later, on news of possible price manipulation the stock witnessed heavy sell-off consistently on every trading day. But my friend failed to book profit in the hope that the stock will recover. The true reason is that, the sudden fall in the price, led to loss of profit which he failed to book and he was not willing to sell at lower profit as against the high notional profit his investment was. The stock fell to a low of Rs.22.35 and his total investment turned negative. My friend is not the only one and many more would have acted similarly with greed.
Importance of risk management
Risk management is very important to avoid financial devastation. Risk management forms part of financial planning. Without risk management, the financial planning will be an incomplete one. When we think of constructing a house, we prepare the plan, we estimate the cost and take steps to arrange for finance before actually starting the construction. Similarly, when we invest, it is vital to have a plan of the investment, identify the risk along with the cost and also to have the tools in place to manage the risk.
Risk management is necessary to minimize the investment loss to the acceptable or tolerable level. Further, when we anticipate and are prepared to face the risk, the less we are affected at least emotionally.
Now let us see some of the consequences of failing to have risk management.
1. Occasionally, not only individuals, even governments and large institutions fail to have risk management in place. The recent increase in non-performing assets (NPA) of public sector banks in India is a classic example. Thousands of crores of money were lent to some corporate houses and tycoons without proper credit and risk analysis. The default on the part of such borrowers lead to sharp increase in NPA of the banks involved.
2. Another similar example would be the case of sub-prime mortgage that led to recession in the year 2008. In US, home mortgage loans were given to borrowers without proper credit analysis . Investment firms and fund managers also bought these mortgage backed securities which led to vast financial disaster.
3. In case of individual investors who are in fancy of one sector or stock tend to put all their money in their favorite one stock or sector. This type of investment is prone to unsystematic risk. In this case, the investment portfolio will take a hit on any company or industry specific downturn or mismanagement.
Investing without proper risk management is similar to a soldier facing battle field without armour. As with any thing in this world risk is prevalent in finance too. Hence, to attain the goal of profit proper risk management should be followed with appropriate tools.
Tools of risk management
Various tools are employed to manage the risk involved in investment. Under the heading what is risk management, we saw the causes of risk in investment. Now let us see about the tools that are available to mitigate those risks.
Asset allocation and diversification
Asset allocation is the primary step in successful financial planning. It is a process where investment is made in various asset class in a proportion that commensurate with the objectives and risk appetite of the investor. For example, if the investor is risk averse or nearing retirement he can choose a portfolio with major allocation of funds to income generating debt instruments and less allocation to risky and growth oriented equity investment. An investor can spread his investment across various asset class such as equity, debt, gold and property.
Investment spread across asset class or across company or industry is called diversification. Unsystematic risk such as defaulter risk, company or industry specific risk can be minimized by using this popular technique called “Diversification”. This will reduce the investment's exposure to risk associated with particular industry or company.
By way of diversification, the unsystematic risk can be eliminated. It helps in balancing the risk in investment by making good the loss in one asset by the profit in another asset, thereby securing the overall profitability of the portfolio.
In addition to diversification, position sizing is equally important in risk management. It is the process of determining the right percentage of position to be held in each asset class. Position sizing should be done according to the objectives and risk appetite of the investor. Different strategies can be formulated in an equity portfolio and position sizing can be done based on market capitalization of the stock or based on sector. However, lot of research is required to arrive at the best proportion of assets to be held in a portfolio. This aspect will be discussed in a separate module in detail.
Stop loss and exit strategies
Stop loss and other exit strategies should be followed strictly to mitigate the risk of incurring heavy loss. Setting stop loss not only pertains to intraday trading, it can be applied to investment also. The common mistake that many investors do while investing, especially in stocks is they fail to exit at the right time. Exit strategy is important in risk management. Investment opportunities keep changing according to economic changes that takes place from time to time. This calls for shuffling of investment portfolio to seize the opportunity in investment world. Investors should lock in the profit and should not hesitate to exit the investment at appropriate time.
Hedging is another tool widely used in risk management. Hedging is used to mitigate the unforeseen risk in an investment. Hedging helps in off setting the loss in one investment by the profit in another position. Hedging can be done by initiating an opposite position in an equal amount of the original investment. For example, the investment in stock “A” can be hedged by selling the futures contract of stock “A”. If the stock price falls, the investor will be making loss in his portfolio which can be offset by the profit made in futures contract. Hedging can be done for investment made in commodities, currency and equity. This will be explained in detail in separate module.
Key points to remember
- Risk management means identifying the risk, evaluating and planing measures to mitigate the risk.
- The risk that can be eliminated is known as unsystematic risk and those that are out of our control are called systematic risk.
- An investment plan without risk management is more prone to be financially disastrous.
- Asset allocation and diversification, exit strategies, position sizing and hedging are the tools of risk management.
Risk management is key to success in investment. Investment without proper risk management in place will be devastating during times of downturn. On deciding upon the investment asset, investors should identify the risk associated with the particular asset and have a proper tool to manage the risk.