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“Chand pe Daag” – The Risk of Equity Investing.

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What is the Risk of Equity Investing?

Extending the same analogy of “Daag” as “Risk” from the last article “Daag Acche Hain”, further. The “Chand pe Daag” is permanent, and so is the risk of equity investing – it’s a perpetual part of investing. In no way, these “Daag” on the moon either belittle or steal away its beauty; it still shines away with all its magic. Understanding, the risks of equity investing, ways to mitigate them, and managing our behaviors, will help us appreciate the “Daag” and create wealth.

Risk and returns are positively correlated in investments. Higher return accompanies a higher degree of risk. Equity Investment has the propensity to deliver higher returns hence it carries a higher degree of risk. Alternatively, avoiding this risk will lead to lower returns – perhaps the post-tax returns could be lower than (headline & lifestyle) inflation – permanently destroying the purchasing power of money.

The above risk is like trying to beat the treadmill by running on it – highly improbable. This is what makes “Investing a necessity and no longer a choice”. The risk of equity investing cannot be eliminated. However, the good news is that it can be skillfully navigated through prudent risk management practices, making investing a more secure and sustainable choice.

Risk Mitigation – Diversification and investing for a longer time horizon are two smart ways to mitigate the risk of equity investing.

Diversification – By investing in two or three equity stocks the risk will be higher – this can deliver outsized returns if the trade plays in favour and likewise it will cause severe wealth destruction if it doesn’t- concentration risk. The solution therefore lies in diversification- a way of owning more than just a handful of equity shares, thereby reducing the risk of equity investing & volatility; it surely mutes the return propensity marginally but certainly carries a much better return to risk trade-offs.

Time Horizon – is another way that works while investing in an Index / ETFs or Mutual fund portfolio but may not work while investing directly in individual equity shares. The graph below illustrates the point with BSE Sensex reaching 20827 points on 6th Jan 2008.

The Sensex swayed between the same range until 27th October 2013 (21196 points). It only broke past the range after 5 years and then never looked back. Investors who waited patiently for the time correction, managed the interim volatility risk of equity investing

However, the same did not apply to direct equity shares investing. Individual equity shares carry a much higher degree of volatility (technical term: standard deviation) and also carries the mortality risk (the risk of businesses going bust/ dead). The SENSEX / ETF / Mutual Funds – they mitigate this risk by investing in a bunch of companies; highlighting the first point on diversification.

Diversification married with long-term investing is a smart way to mitigate the risk of equity investing.

If it’s that simple then why is it difficult to make money from Equity? 

If markets and people were rational, everyone would have access to the same information, everyone would peg the same amount of risk for the investment and then the expected return would also be the same unless someone exhibited irrational behaviours. A person’s risk tolerance level during good times may be different from that of bad times; most often an individual’s risk tolerance drops significantly when equity markets crash. Unfortunately, in the real world, it is difficult to be rational. We are all rationally irrational. So, what do we do?

When the fear of loss of money fires the amygdala in our brain then it is nearly impossible to think calmly and use the reflective brain. Yet, there is no harm in trying with a checklist.

The “Behave yourself” checklist – The behavioral checklist is an investment framework, that focuses on the core reason why & how of equity investment.

1. Long-term money only –Equity investment must be viewed as a robust investment opportunity, either to fund long-term goals or to create wealth over the long term. One may get lucky with short-term investing, but most often it proves very fatal.

2. Purpose & Scenario – When the market corrects reflect upon the core purpose or reason for investing that money into equity. Has that purpose/goal or your scenario changed? If not, stay invested.

3. Direct Stock – Buy equity stocks for the value and not the price. Most often if someone buys the stock because its share price is moving up then it’s most likely to sell if it drops on bad news. Behave like the company owner while investing in the shares of a company; one would not sell the company just because its share price is up by 20%. Sell the stocks not for a temporary drop in stock prices but if there is a fundamental decline in the business value.

4. Equity Mutual Fund – As stated, Equity Mutual Fund is a smart alternative to direct stock investing; for the majority MutualFundSahiHai. It is difficult to predict the next best equity fund, hence one must stay invested unless there is any fundamental change in the invested fund (i.e. – Change of Fund Manager, funds philosophy changed, etc.) or the fund has consistently underperformed for more than 4 quarters.

Also Read: Equity Mutual Fund VS Debt Mutual Fund: Which is Better?

5. Systematic Investment Plan (#SIP) – These small SIPs take away the trouble of timing the market. Once in a while exercising or an inconsistent fitness regimen does not get you that six-pack abs. It’s a result of small consistent efforts over the long term that reaps the magic of compounding to create long-term wealth.

“The only end of writing is to enable readers better to enjoy life or better to endure it”.Dr. Samuel Johnson