2.1 - Risk reduction

A trader must lose one rupee for every rupee it makes in profit. This is a continuation of the previous statement. If a group trades consistently makes money, there must also be a group that consistently loses money. This group that consistently makes money is usually smaller than the traders who lose money.

These two groups are different because of their knowledge of risk and money management techniques. Mark Douglas, author of "The Disciplined Trader", states that successful trading requires 80% money management and 20% strategy. I couldn't agree more.

Risk assessment is a key component of money management and other related topics. Understanding risk and all its forms is crucial in this context. Let's take a look at risk in its simplest form and get a better understanding.

In the stock market context, risk is defined as the "probability to lose money". You are at risk when you trade in the stock market. This means that you could lose money. You are, for example, exposed to risk when you purchase stock in a company. At a very high level of risk, you can break it down into two types: Systemic Hazard and Unsystemic Danger. Stock ownership automatically exposes you to both of these types of risk.

You might ask yourself why you are liable to lose money. In other words, what is the most likely reason to lower stock prices? There are many reasons that can cause stock prices to drop, as you can see, but I will only list a few.

1. Business prospects are declining
2. Business margins are falling
3. Management misconduct
4. Margins are being eaten by competition

These are all risk factors. There could be other reasons that are similar to these, and the list could go on. But, you will notice that all of these risks have one commonality: they are all risks unique to the company. Imagine that you have Rs.1,00,000. This money is decided to be invested in HCL Technologies Limited. HCL announces that revenues have fallen a few months later. HCL's stock price will decline, which is quite obvious. This means that you will lose money on the investment. This news won't impact HCL's stock price (Mindtree, Wipro) however. HCL's stock will also drop if HCL's management is found guilty of misconduct. These risks are unique to HCL and its only company, and they do not apply to any of its competitors.

Let me clarify. I don't know how many traders were in the market when the "Satyam scam" broke out on January 7, 2009. Yes, I was there and I still remember that day. Satyam Computers Limited was a fraudster, manipulating funds and inflating numbers for years. These numbers were far higher than the actual number of internal transactions that led to inflated stock prices. The bubble burst when Mr Ramalinga Raju (the former Chairman) made a bold confession to this financial crime in a letter addressed directly to investors, stakeholders clients employees and exchanges. He took such a big step. It takes courage, especially when you know the consequences.

However, I can still remember being stunned when Udayan Mukherjee read this extremely explosive letter live on TV as the stock market plummeted like a stone falling off a cliff. For me, this was the most chilling moment in the market.

Let me remind you of a few things.

1. The stock price drop rate (btw, it continued to fall to as low 8 or 7).
2. You can spot Satyam's scrolling ticker if you are able to notice how other stocks have not reacted to Satyam’s big revelation.
3. You can see the decline in the indices (Sensex, Nifty) but they don't drop as much like Satyam.

This is the simple truth: the stock price drop can be completely attributed to the company's actions. The price drop is not affected by any external factors. This is a better way to put it: at that point, stock prices can only be affected by company-specific or internal factors. The risk of losing money for company-specific reasons (or internally) is often called " Unsystemic Hazard."

Diversification is possible to reduce unsystemic risk. This means that instead of investing in one company, you could choose to invest in 2-3 other companies, preferably in different sectors. This is known as diversification. Unsystemic risk is greatly reduced when you diversify your investments. As an example, instead of purchasing HCL for its entire capital, you might decide to purchase HCL at Rs.50,000/ and Karnataka Bank Limited at Rs.50,000/. In such situations, even though HCL stock prices decline (due to unsystemic risks), the damage to HCL's investment is limited as half of it is invested in another company. Instead of having just two stocks, you could have five, ten, or even twenty stock portfolios. Your portfolio's number will determine how diversifiable it is and the extent of unsystematic risk.

We are now faced with a crucial question: How many stocks should a portfolio contain to ensure that unsystemic risk is fully diversified? Research shows that a portfolio should contain at least 21 stocks to achieve the necessary diversification effect. Anything beyond 21 stocks could cause problems with diversification. My equity portfolio currently contains 15 stocks.

This graph should give you an idea of the principles behind diversification.

(image 1

The graph shows that the unsystemic risks are greatly reduced when you diversify your portfolio and add more stocks. The graph begins to flatten after 20 stocks. This is because the unsystemic risks are not easily diversifiable. The " Systemic risk" is the remaining risk even after diversification.

Systemic risk refers to the risk that is shared by all stocks on the market. Common market factors like the macroeconomic environment, political situation and geographical stability, as well as the monetary framework, can all contribute to systemic risk. These systemic risks can cause stock prices to drop:

1. De-growth of GDP
2. Interest rate tightening
3. Inflation
4. Fiscal deficit
5. Geopolitical Risk

As usual, the list can go on, but you should have a good idea of what constitutes systemic risk. All stocks are affected by systemic risk. If you have 20 stocks that are well-diversified, then a decline in GDP will affect all 20 stocks. This will cause stock prices to drop across the board. The systemic risk is inherent in the system , and cannot be diversified. While 'unsystemic' risk can be diversified, systemic risks cannot. Systemic risk can however be "hedged". Hedging is a skill, a method to eliminate systemic risk. Hedging is like having an umbrella on cloudy days. You can instantly secure your head with your umbrella when it starts to pour.

When we talk about hedging, keep in mind that diversification is not the same thing. Diversification is often confused with hedging by market participants. They are two distinct things. We diversify to reduce unsystemic risk. We hedge to minimize systemic risks. You'll notice that I use the word "minimize" to emphasize the fact that there is no way to be certain about any trades or investments in the market.

It's not mine.

2.2 - Expected Return

Before we get back to Risk, we will briefly discuss the concept of "Expected Return". Everyone expects a return on their investments. It is easy to see the expected return on investment - what you should expect from it. You can expect to earn 20% in Infosys if you invest in Infosys.

This seems like an obvious question, but why is it so important? Finance plays a critical role in determining the expected return. This number is used to calculate portfolio optimization and equity curve estimation. In a way, investing management is based on the expectation of a realistic returns. We will continue to discuss this topic. Let's stick to the basics for now.

The above example shows that if you invest Rs.50,000/year in Infy and expect a 20% return, your expected return on your investment will be 20%. What if you instead invest Rs.25,000/in Infy to get a 20% return and Rs.25,000/in Reliance Industries to get a 15% return? What is the expected total return? Does it have to be 20%, 15% or another number?

As you might have guessed the expected return on investment is not 20% or 15%. We made investments in 2 stocks. Therefore, the expected return of a portfolio is not the individual asset. This formula can calculate the expected return for a portfolio.

E(RP), = W1R1 + +W3R3 + +WnRn

Where?

E(R P) = Expected Return of Portfolio

W = Weight of investment

R = Expected Return of the Individual Asset

The above example shows that the investment is Rs.25,000/- per unit, so the weight of each unit is 50%. The expected return on both investments is between 20% and 15%. Therefore, -

E(R P = 50% * 20% + 50% 15%

10% + 7.5%

= 17.5%

This concept can be applied to any asset or asset class, even though we have only used it for two stocks. It is an easy concept and I hope that you have no difficulty understanding it. You must understand that the expected return isn't a guarantee. It is merely a probabilistic expectation for a return on your investment.

We now have a better understanding of expected returns and can use this knowledge to build some quantitative concepts such as variance and covariance. These topics will be discussed in the next chapter.

To Summarize

1. You are at risk of unsystemic or systemic risks when you purchase stock.
2. Unsystemic risk is the risk in a stock that does not exist within the company.
3. Unsystemic risk only affects the stock, not its peers
4. Simple diversification can reduce unsystemic risk
5. Systemic risk refers to the risk that is prevalent within the system.
6. All stock is subject to systemic risk
7. To mitigate systemic risks, one can hedge.
8. There is no perfect hedge - so there are always risks when transacting on the markets
9. The expected return is the probability of a return
10. The return expected is not a guarantee
11. The expected portfolio return can be calculated using the following formula: E(RP) = W1R1+ W2R2 + HTML3R3 + -------