In investing, ‘risk’ implies the possibility of losing capital. In this context, different types of securities are placed at different levels on the risk ladder. While debt securities such as bonds, debentures, debt funds, etc. are at the lower rungs of the risk ladder, equities are placed at the highest rung of the ladder.
Risk is directly correlated to potential returns that a security can offer. For instance, while debt securities carry lower risk, their return potential is also modest. On the other hand, equities carry the highest level of risk, but their return potential is the highest too.
All this sounds commonsensical, but how do you measure risk? There are different types of risks like market risk (the risk of price fluctuations of equity shares or bonds), credit risk (the risk of a lender defaulting), etc. But, can you really estimate these risks?
There are intricate and complicated ways of doing this, not always comprehensible for the layperson. For example, to measure market risk, price volatility of the investment needs to be calculated. If the price of a stock fluctuates wildly, it is supposed to carry a higher risk (beta), and vice versa. Beta is the metric that measures price volatility of a security. Like several other measuring tools, this one too suffers from several drawbacks like attaching too much importance on historical price data and having a narrow focus. Beta measures historic volatility but risk does not just stop there. It needs to also factor in industry outlook, business cycles, management, competition etc.
Warren Buffett, unarguably this planet’s most successful investor, simply states that risk is primarily dependent on the price you pay. For example, if you were to buy a tola of gold for Rs.50,000, it is riskier than buying it for Rs.40,000. Simultaneously, the expectation of reward is higher when you buy it at Rs.40,000 as against Rs.50,000. Buffet again: “The greater the potential for reward in the value portfolio, the less risk there is”.
When you buy gold or a house, you instinctively measure risk based on the price you pay. Its not rocket science to know that a good bargain carries lower risk with a higher reward potential. But, when you buy stocks, the first thing that is thrown out of the window is this commonsensical attitude. You are swayed by sentiments, rumors, betas, operator interest, etc.
When you buy a stock, you are buying a part of a business. To know whether you are getting a good deal is to have the ability to evaluate the business and find out whether you are getting a good bargain in the stock markets. One of the main reasons investors don’t do this is the difficulty of valuing businesses. Though not as simple as buying a house, where you can compare it to prevailing prices in the neighborhood, it is not impossible. You can approximate the value after studying the industry, company, management, competition etc. It is this study that enables you to reduce risk.
As no calculation of value will be exact, factor in what Buffett calls “margin of safety”. If a stock is available at a significant discount (margin of safety) to its value, lower the risk and higher the potential reward. Successful investing is reducing risk and consequently increasing returns, and not as popularly understood, balancing risk and reward.
Milan is a veteran stock market investor and educator on equity investing. Connect with him on firstname.lastname@example.org