While managing their portfolio and investments, most investors tend to focus on how much they can earn, rather than how much they stand to lose if things don’t go according to their plans. Evaluating the risk exposure of a portfolio is crucial for investing, for long term gains and wealth creation.
Warren Buffet, one of the best investors in the world, has a golden rule-
“Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.”
Investing will lead to losses as well as gains. However, assuming too much risk and hoping for higher returns is a dangerous way to manage your money. So, why is this the case if we know that, historically speaking, stocks tend to rise and outperform all categories of investments? Why not just invest our money in a passive index fund and hope for the best?
One of the basic things to learn while managing a portfolio is risk management. A loss-avoidance strategy seems against conventional market wisdom nowadays. Today, most people would have you believe that the risk comes, not from owning stocks but from not owning them. Judging the actual risk of investment only on historical data is a fallacy. It is also a part of the representativeness bias (Judging the probability of event A happening on the basis on how closely it resembles event B, even though event A and B are separate. Here, the bias is thinking that the trend of gains in the past will be repeated in the future without any downsides.)
Thus, the risk an investor should take depends on the price that they are paying. A small investor shouldn't gamble their rent payment on speculative intra-day trading. It would be better for them to only invest the money that they can afford to lose, and start with a mutual fund to grow their investment over time.
Another common belief that people hold is that risk avoidance is incompatible with an investment’s success (Higher the risk, higher the reward). While this may be true in the very short term, the long term effects are quite opposite to this sentiment. Minimizing risk is necessary for successful investing and getting consistent, stable returns over time. An investor has more probability of doing well by getting lower but consistent gains, than by achieving a large amount of return, which is volatile, at significant risk to the principal.
The mathematics of investment loss
Let’s illustrate the importance of analyzing negative and positive returns in our portfolio:
Suppose there are two options to choose from:
Which option will you choose? Most people will go for the first option because of higher average returns and bigger yearly returns which offer more excitement. However, the value of Rs 100 after 4 years is Rs 129.6 in investment 1 and Rs 157.87 in investment 2. The boring, stable investment with consistent returns outperforms the seemingly better option.
This is why focusing on the downsides and possibly negative returns are so important. If a person with Rs 100 loses 25% of their money and has Rs 75, it will take 33% gains to get back to Rs 100.
Investors drastically underestimate the risks involved in the stock markets as over-optimism and over-confidence make it easier to see the future with rose-tinted glasses.
You may find an answer in ‘value investing’, a better way to invest and grow your wealth.
Value Investing is an investing strategy that looks at an investment’s intrinsic value rather than its market price, to ascertain if the investment is over-priced or under-priced.
This philosophy involves managing risks by factoring in a margin of safety (the difference between a security’s intrinsic value and its market price). A value investor makes investments for longer periods and ensures that the risk assumed is minimized so that a downturn in the markets does not cause a huge loss in their portfolio.
Along with this, the portfolio’s assets should be allocated per the investor’s risk tolerance. Having almost all of one’s investments in risky instruments can cause a huge panic if there is a crash in the markets, and it will lead to hasty and foolhardy decision-making at that time.
In conclusion, recovering from huge losses is worse than having spectacular gains as it is important to not lose money than to gain a lot of money.
Even though positioning yourself conservatively takes a lot of patience, it is a prudent thing to assume that a bear market is just around the corner.
Think about it, if you invest Rs 100 and that falls to Rs 50, it is a 50% loss. After the fall, just to come back to Rs 100, requires a 100% gain from the fallen value of Rs 50.
In conclusion, recovering from huge losses is worse than having spectacular gains as it is important to not lose money than to gain a lot of money.
Even though positioning yourself conservatively takes a lot of patience, it is a prudent thing to assume that a bear market is just around the corner.
Think about it, if you invest Rs 100 and that falls to Rs 50, it is a 50% loss. After the fall, just to come back to Rs 100, requires 100% gain from the fallen value of Rs 50.
Disclaimers
Investment in securities market are subject to market risks. Read all the related documents carefully before investing.
The securities quoted are for illustration only and are not recommendatory.
Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.
Details of the advisor
Advisor: Ankur Kapur
SEBI RIA No.: INA100001406
BASL Member ID: BASL1337