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Understanding Stock Market Risk

Updated: Mar 18

When a crisis occurs and something as enduring as the current Pandemic, stock markets can be really cruel. The scale and speed of the fall could be severely harsh wiping off even 10-year average returns in a brief period. It is natural to feel anxiety, confusion and fear about our investments. I am sure there would be many investors who have vowed never to invest in the stock markets again. There would be majority who have sold in this falling market.

But there has been crisis earlier and it’s the same story which unfolds every time. While the triggers are different, the script tends to be familiar. Sadly, majority investors do not learn their lesson well.

This is because they do not truly understand a major factor in the world of investing. While investors are aware that stock markets are volatile and they fluctuate, they do not understand ‘RISK’ in a true sense.

For some investors, preservation of capital is more important than taking risk. For some, chasing high returns is a priority and do not mind to take some risk. Then there are also a few who want high returns but in a short span of time but with minimal risk.

It is thus important for investors to first decode their risk profile. For this purpose, it is very important to understand the difference between risk capacity, risk appetite and risk tolerance.

  1. Risk Capacity: It is the ability to take risks depending upon the personal situation of an investor like his age, income, number of dependants, investment horizon, etc.

  2. Risk Appetite : It is the willingness to take risks and would define an investor’s preference for different asset classes like debt, equity, real estate, etc. This would also depend upon his circle of influence like his family, friends, work colleagues, etc.

  3. Risk Tolerance: It is the downside risk/loss that an investor can actually withstand in his portfolio. This is truly tested when a market crash/downturn occurs and has more to do with emotions.

An expert financial advisor can thus help an investor to decode his risk profile by asking the relevant questions and recommend investments accordingly in the appropriate proportions.

Further, what investors do not realise is that investing in stock markets is all about taking calculated risks. As Craig Elliot popularly quoted “A chance is what you take before you think about it. A calculated risk is what you take after you have evaluated all possible factors and have determined that risk.

To illustrate, we all are aware about the risks in driving a two-wheeler. There could be an accident which may damage the vehicle, maybe some pedestrian can be hurt or we may lose our life. Yet, we still choose to drive daily to reach our destination. Why? Because we know to drive the two-wheeler and are fully aware of the consequences of any rash driving. We deal with the uncertainty in a manner so as to minimise the risk, if not eliminate it. We drive with limited speed, wear a helmet, avoid to overtake other vehicles and stick to the line in a journey. Thus, we take calculated risks to minimise chances of any accident. We go a step further in risk management to minimise any possible financial damage by taking life & health insurance for self and vehicle insurance for car. Similarly, we can take calculated risks in stock markets. How? Through Asset Allocation. This would entail diversifying investments across different assets like equity, debt, real estate, gold, etc depending upon one’s risk profile, long & short-term goals, etc. Asset allocation requires periodic rebalancing wherein if any particular asset class is overheated, profits can be booked and apportioned to underweight assets. Since all asset classes do not move at the same pace or in the same direction, the overall impact of any one asset value going downhill is minimised in the total portfolio.

The significance of Asset Allocation cannot be undermined particularly now in this Pandemic scenario. It is easy to tinker with it when markets go into a tailspin and when there is so much uncertainty. It is crucial at this hour for you as an investor to overcome your biases and stick to your long-term plan and goals. The one who understand RISK can manage it wisely through asset allocation and also manage his emotions well.

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