Assessing your risk tolerance should therefore be an important element of your investment decision. It can be tricky though, you must consider not only how much risk you can afford to take, but also how much risk you can stand to take. What you can afford depends mainly on your time horizon i.e. how long before you will need the money.
Balancing operating and price risks
When it comes to understanding the risks associated with investing in the stock market most people, by far, learn the hard way. They invariably invest without due understanding of the stock in particular and the economy in general. I find breaking down risk on the lines of operating risk and price risk is particularly helpful way of looking at stocks. Operating risk is the risk to the company as a business, basically, anything about the business that makes its earnings less certain or more unstable qualifies as operating risk; whereas price risk on the other hand, has more to do with the stock than the business. There are different ways to look for price risk, but the most potent is looking at the stock’s P/E (Price/Earning) as against that of the industry, market. When you look at a stock, try to figure out how its operating risk balances its price risk.
Market Risk & Time
While the stock markets can be risky in the short run, time has moderating effect on market risk. The longer you hold a stock, the lower your chances of losing money, and the greater the odds of earning a return close to the long term average. For example a one year investment in stocks has historically produced returns ranging from +57% to -43%. Over ten year periods, however, returns have varied from -1% per year for the worst ten years to +20% per year for the best ten years. As you can see, over longer horizons the chances of losing money is substantially reduced.
Diversify risk
When the stock market takes a tumble, all stocks/sectors/Indices don’t take an equal hit. Some indices are more affected as compared to others. For example during the infamous Harshad Mehta scam it was the banking sector which faced the most heat and therefore lost majorly in comparison to other sectors. Likewise when the IT bubble burst in early 2000’s it was the technology stocks that went for a toss. Had you been invested in any of these sectors during the respective crises, chances are that you would swear never to enter the markets again. But, if the same quantum of money were to be invested by spreading it over a variety of stocks in different sectors, the eventual effect would not have been so severe.
There are risks in practically all aspects of life that we deal in, but we find ways and means to counter them effectively so that they don’t deter us from our objectives. Mankind has always searched for an antidote whenever faced with the risk of an epidemic. The bottom line is there will always be pit stops when it comes to investing, but with methodical planning, systematic approach and a little bit of street smartness we can counter risk even without breaking into sweat. After all only those who will risk going too far can possibly find out how far it is possible to go.
