Almost every other person wants to invest in stocks but there are certain share market risks that stop them from planning their investment goals accordingly.
There is no doubt behind having this fear in mind, but there are alternatives that can help you in getting rich or generating the source of passive income when planned strategically.
Thinking what are they?
We are here to talk about this aspect in detail and try to understand and minimize these risks. But, before that, we need to know the major risk that hovers over the stock market.
It is the chance of bearing losses by the trader or investor because of factors that impact the financial market performance.
It is also known as ‘systematic risk’, and it is impossible to eradicate it in its entirety, but he or she does attempt to minimize it.
Share market risk has multiple factors like political turmoil, alteration in interest rates, natural disasters, man-made disasters, recession, or other unprecedented economic situations.
Irrespective of which of these occurs, the market is influenced simultaneously but with varying impacts. It is contrasted by ‘unsystematic risk’.
Unsystematic risk is known by many names, such as nonsystematic risk, specific risk, residual risk, or diversifiable risk.
The names suggest clearly that this risk can be diminished by diversifying the investment portfolio.
Share Market Risk Types
Above we discussed the two categories of risks and now, we should focus on the types of share market risks. It is necessary to analyze the risks associated with your investments.
Thus, understanding the types of risks you are prone to become mandatory.
A trader or investor must know about the various share market risk types that impact their trades or investments. They are – Interest Rate Risk, Equity Risk, Commodity Risk, and Currency Risk.
1. Interest Rate Risk
The name very well explains this risk. When the interest rate changes due to a range of reasons like central bank announcements, monetary policy changes, or other fundamental factors, they come under this risk type.
This type covers all this volatility. The most impacted investments are fixed-income securities like bonds.
2. Equity Risk
It revolves around the changes in the price movements of stocks and other investment instruments.
Commodity Risk includes the fluctuations of prices in various commodities, i.e., agri or non-agri like crude oil, metals, oilseeds, spices, precious metals, grains, etc.
4. Currency Risk
This risk is also known as exchange rate risk as it corresponds to the ups and downs of a currency against any other trading currency. Currency risk is a significant risk to the investors or firms that hold assets in another country.
With the types of share market risk discussed, we should move to the next topic, analyzing the share market risk.
Either of them use various ratios, charts or indicators to predict the price movements. Some of these ratios and indicators are commonly used. These necessary tools used to identify the share market risks are listed below:
1. Standard Deviation
This tool helps in measuring the deflection of the price movement from the expected value. It identifies the historical volatility of a particular investment compared to its rate of return annually.
You can easily calculate the difference between the current prices and the historical normal.
To understand this with an example, let’s suppose that the shares of HCL Technologies are currently trading at ₹50, and their return is ₹5 annually.
Historically, the share price has been ₹45, and the annual return rate was ₹4.95 then. This data shows minor deflection from the historical trends and has lower risk and volatility levels.
Contrarily, if the deflection were higher, the volatility and risk rates would have increased and become a less favorable investment.
It is a commonly used risk measurement tool that evaluates the extent of systematic risk an industrial sector or individual financial instrument has to the whole stock market relatively.
The beta of the market is 1 and is used to gauge the risk involved in financial security. So, if security has a beta value of 1, the price movements are parallel to stock market movements.
If the value is more than 1, it is more volatile than the market as a whole. On the other hand, if it is less than 1, the volatility level is lesser than the markets.
For instance, let’s suppose that TCS has a beta value of 0.75, it is less volatile, and TATAMotors has a value of 1.2, it is more volatile.
3. Sharpe Ratio
This tool is majorly used for measuring the share market risk on potential returns of a mutual fund, which is known as a risk-adjusted return. Are you confused about what exactly is a risk-adjusted return?
Hold on! We got you!
They are the returns earned by the investor or trader in comparison to the returns given by a risk-free asset like a Government Bond or Fixed Deposit (FD). The difference between the two return amounts is called ‘Extra Risk’.
This risk is calculated by using the Standard Deviation of the security. The formula is as follows:
Sharpe Ratio = (Average Fund Returns – Risk Free Rate) / Standard Deviation of Fund Returns
So, a higher Sharpe Ratio translates to better chances of yielding a higher return.
Suppose Reliance Industries has a Sharpe Ratio of 1.25 per annum; it generates 1.25% higher returns against every 1% of annual volatility added to the security.
When the percentage of price movement for a particular financial security is measured against the movements of a benchmark index, the statistical value we get is known as R-squared.
The benchmark index for every segment is different. Basically, there are two indexes of the stock market i.e., Nifty and Sensex
This value ranges anywhere between 0 to 100. A value closer to 100 is considered to move like the index, and the closer it is to zero, it doesn’t perform like the index.
For instance, let’s suppose that Kalyan Jewellers have an R-Squared value of 95. There are high chances that the price movement will be proportional to the index movement.
On the other hand, Yes Bank supposedly has a value of 35. This value reflects a lesser chance of replicating the index performance. These values are divided into three tiers:
1% to 40% – Low Correlation to the Benchmark
40% to 70% – Average Correlation to the Benchmark
70% – 100% – High Correlation to the Benchmark
5. Value at Risk (VaR)
This tool for share market risk analysis assesses the risk associated with a company or portfolio. The maximum potential loss with a degree of confidence is what VaR measures and is done for a specific period.
Let’s suppose that Burger King has a 10% VaR for ₹1 Lakh investment price to understand this with an example. So, the investor has a 10% chance of bearing the loss of more than ₹1 Lakh over one year.
An extension of VaR is CVaR (Conditional Value at Risk). This tool measures the tail risk of an investment. Tail risk is the events that happen at the tail end of a distribution.
The difference between VaR and CVaR is that the latter tries to assess the risks beyond the maximum loss threshold.
To ease the understanding of this concept, let’s suppose that TCS is believed to invest ₹10 lakhs with an average loss for the one percent of possible outcomes. Thus, the CVaR is ₹10 lakhs for a one percent tail.
As we have gained an understanding of the share market risk analysis, let’s walk over to the management of this risk.
Share Market Risk Management
It is very important to manage the share market risk while taking all the precautions as you, as a trader or investor, bear the brunt of this double-edged sword.
So, let’s begin with understanding the need for share market risk management.
The factors that affect the market are recessions, inflation, interest rates, economic growth, currency, fluctuations, and other such factors.
The occurrence of these are highly unpredictable because of which, volatility and risk is created in the market.
Volatility is the invisible knife that works to reduce your profits. So, taking additional risks might seem profitable but it would unwise to ignore the risk quotient.
Further, the traders and investors are unable to give up the herd mentality.
In simple words, this phenomenon is when people tend to ‘follow the crowd’ and involve their emotions into the trading process. It makes them buy more when prices rise and sell when the prices dip or they incur losses.
A riskier investment is certain to be fundamentally weaker and smaller than its peers and a speculative stock will lead the market up in rallies but nosedive when the markets collapse.
Another problem is increasing the concentration of high-risk stocks.
As the share market prediction of a collapse or rise is impossible to predict, the investor must learn to manage these unprecedented risks that make their investment portfolios vulnerable.
Below are a few things commonly done by traders and investors alike.
Use Tactical Asset Allocation
The intelligent traders and investors of the stock market become most active during times of volatility.
They buy when the asset prices are bargained in the market and own the minimum possible assets when the asset price is expensive. But prior to that, it is best to know all the rules of share market.
Past is the perfect example for observing the rates of return in either of the cases. Stocks bought when valuation low tends to give higher returns and lower returns when the valuations are high.
Develop Value Rules and Strategies
Any trade or investment with no strategy or plan is nothing less than a time bomb waiting to explode. You must have your goal based investing research, strategies, risk appetite, and rules figured out beforehand to avoid any last-minute chaos.
If you don’t, the unpredictability of the stock market plays with one of these and you end up losing more than expected.
Establish a Maximum Portfolio Drawdown Policy
Setting your investment limits is extremely important. The Maximum Portfolio Drawdown policy sets this limit for you. It limits the amount of decline the investor is willing to tolerate.
This policy also helps in reducing emotional asset allocation changes.
An investor or trader wants to be sure that the risk is minimized and returns are higher. For this to happen, you must analyze the share market risk associated with the security you are eyeing and then buy it at its low.
This small exercise helps you focus on the value, price, and gives you time to plan ahead.
These were some of the most used ways to manage your risk in the share market. Some of you might be facing some issues even after following these steps.
Thus, in the next section, we will discuss the methods to reduce your share market risk further.
How to Invest in Share Market Without Risk?
As a trader or investor, you would not want to invest or trade in securities that have higher volatility. You might be ready to take risks in the market but there is always a limit to the risk an individual can bear.
So, in this section of the discussion about share market risk, we will talk about some ways to reduce your risks to the minimal levels possible.
Below is a list of four such methods and they are discussed in detail.
Know What You Own And Why?
Do you know that this tip is also supported by the richest investor in the world – Mr. Warren Buffett?
He agrees with the fact that you must be clear as to what and why you own. It is crucial to know why you want to invest in a company by buying its stocks or sharesor any other forms of securities.
If you have confusion about what stocks and shares are, review Stock vs Shares in Detail and get your doubts cleared.
Nowadays traders and investors tend to ignore the fact that they are actually investing and not just earning profits from the price movement.
You must learn about company operations, financials, and other factors before investing.
An investment made without knowing the business model is equivalent to shooting in the dark.
Diversify Your Portfolio
Imagine you have to eat just one food item for the rest of your life. Not only is this arrangement boring but also has a nutritional lag. You might miss out on many necessary vitamins and minerals.
Are you getting confused about how this is related to the topic? Well, this analogy aptly explains why an investment in just one financial security is not desired.
The biggest blunder by an investor or trader is not diversifying his or her portfolio.
Before investing in the share market it is better to clear about what to invest in stocks? as it will lead you to save from uncertainty in the segments.
By diversification, we mean that an investment in several financial securities from varied sectors, industries, and countries will reduce the share market risk on returns. The degree of diversification is dependent on the investor.
For instance, you invest all your investment amount in just one company or security and the share price of the company falls unexpectedly. Now, aren’t you panicked as if it were true?
-We don’t blame you. It is indeed a chaotic situation. So, it is advised by experienced traders and stock market experts that you should try to diversify your portfolio as much as possible.
The investor or trader should diversify to the level he seems suitable for his investment goals and plans. Diversifying just because it is advised won’t help you achieve the pre-set goals.
Avoid Emotional Investing
It is observed that many people commence the trade or investment with the least bias but in the course, they involve emotions and deviate from the strategy. It leads to higher losses.
Emotions are considered as the biggest hindrance an investor or trader faces every day. Neither the long term nor short term investors are exempted from this bias. Many let the herd mentality take over them and incur huge losses.
Thus, no matter what, the trader or investor should follow the strategy or investment plan decided before it was executed. Stay disciplined and ignore the hype of the market, media speculations, etc.
Have A Long-Term Outlook
The markets are highly unpredictable in the short term but the greatest chance to succeed is by strategies that focus on long-term investment in the market. A long term strategy is observed to have more success rate.
Moreover, you can reduce share market risk by involving for a longer time period. The investment returns are highly dependent on the holding period of security. A short term approach makes it harder to predict the market.
Buying after a rise in the valuation and selling after reduced valuation is a common mistake seen in investors these days.
Therefore, the thumb rule of trading in the stock market is to invest in good companies and for the long term.
We began with learning what share market risk is and have progressed over to analyzing and managing the risks to reduce the level of risks attached to the investments and trades made in the stock market.
Share Market Risk is never fading out or diminishing. It is all about trying to reduce or manage the risk smartly. You should always avoid hasty decisions and emotional investment.
No matter what happens, if you are sure of your decisions, don’t worry about the crowd.
Use the various Fundamental and Technical analysis tools for interpreting the markets and understanding the finances of a company. Just remember, numbers never lie.
So, be careful while you put your hard-earned money into buying security.
The only success mantra for earning profits from the stock market is to be disciplined and plan ahead of time. You should stay vary of which company you are investing in and what is your objective.
Since every trade or investment has a goal, keep your goals clear, and walk through the market trends with clarity.
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