Risk management is often a difficult task for an investor. There is no thumb rule as the risk-taking capacity varies from person to person. Same is the case with the capital employed. Ditto for situation, etc. One approach to taming this beast is to understand it. Let us touch upon some related topics.
The best risk management approach
If one were to rank the merit of risk management approaches based on the profits generated, then it would emerge that doing nothing may be among the top ones, as the wonders of compounding, or profit multipliers like bonuses, splits M&As etc. play out, when you hold the investments for a long time. Some say that the patience is greatest virtue investment, while another school of thought sees such patience a product of forgetfulness or from a financial freedom to let such investments lie idle, and rarely by design. Also, not many have such luxury, especially if the investments are leveraged or tactical and time bound.
Is risk a clear and present danger?
Risk indicates potential loss. The reason why “risk management” or “risk taking” differs with people is because “loss” could be an event either in the present or in the future. In the present, “loss” refers to losing either your capital, or forgoing your profits. Both are tangible, as the realisation of the loss happens in the present. Future loss refers to losing an opportunity to make profits in the future.
What is the ideal beta?
Beta is an excellent measure of volatility, for those attempting to measure the benchmark with one’s investment in terms of index’s performance. If a stock has a beta of 1, it means that for every 1% move by Nifty, the stock would also move 1% in the same direction. This cuts both ways, taking cues from our above definition of risk. If our aim is to lose no more than the benchmark index, then the beta should be 1 or lesser. Clearly, this approach is about preserving your capital. However, if your approach is to prevent opportunity loss, then a beta above 1, would position you to gain more than the benchmark in the future, once the markets head higher.
Does “calculated risk” mean lower or higher risk?
What is risk taking? Or calculated risk? Is it about exposing yourself to loss or damages? Or is it about exposing yourself to loss, given a fair opportunity to gain more than the potential loss? The second one brings in a reward, in addition, but it doesn’t explain the calculated risk enough. Calculated risk acknowledges not only the risk, but also that the odds of incurring risk is low, and there is a certain preparedness to take the loss, in the low chance of such loss event happening.
Let us illustrate this with an example. Imagine you are driving a car on a four-lane road with two vehicle width on each lane. You are on the right side of the lane, close to the median, plying at a fair clip. There is a truck ahead of you, but on the slow track on your left. Suddenly, the truck swerves on the right in order to overtake a car in front of it. The trajectory of the truck takes the form of a semi-circle, with the car at the centre and the farthest point of the arc being closer to the median, and exactly in your path, shortly ahead of you. Let us freeze on this point, as this is the moment at which you assess the risk and decide on a course of action.
The illustration above is self-explanatory. The first approach appreciates neither the risk nor the gain. It is either a result of inability to understand the possible outcomes, or a wilful search for adrenaline rush. The second approach is the direct result focusing too much on what is immediately ahead. Here the driver sees the truck as an obstruction that is here to stay, as he is unable to factor in that the truck has only completed the first half of the arc, while overtaking. The fixation on what is in front of him causes him to shift from a comfortable and well-set path. The third approach can visualise the truck soon embarking on the second half of the arc soon, which encourages him to keep his present trajectory, while also being prepared to step on the pedal after the truck completes the overtaking.
What differentiates the calculated risk taker from a safe driver is knowledge. Knowledge that the truck had not just swerved with the only intention of blocking his path, that overtaking usually happens in a semi-circular trajectory, that trucks usually do not ply on fast lane, etc. In investments too, a calculated risk taker does not in any way under estimate the risk, but he also sees equally appreciative of the risk of losing the opportunity ahead. In other words, risk management is about opportunity management