Ways to reduce risk when investing in stocks

Investing in equity or stocks has long been regarded as one of the best ways to build wealth over time. However, there is also a general belief that investing in stocks is inherently risky, and many people are wary of investing their hard-earned money in the stock market.

This fear is often due to the perception that investing in stocks involves a high level of risk. While it is true that investing in stocks can be risky, there are ways to mitigate this risk and achieve significant returns over the long-term.

To start off, “risk” is itself the most overused and misused term in finance. Finance professionals, investors, mutual fund managers - all have different versions of risk. Let’s first take a look at the most important types of risks associated with investing in the stock market.

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Volatility risk - This is the most commonly used risk measure by industry professionals and money managers. This is the possibility of the value of your investment changing on an ongoing basis. To use an analogy, imagine driving down a winding road with steep hills and sharp turns. While the road may be uncertain - it eventually leads to the destination.

For example in the stock market, buying smaller companies may entail higher volatility than sticking to large stable companies because smaller companies generally face a lot of more uncertainty than larger ones in the short-term.

Drawdown risk - This is the risk that is associated with sharp declines in the value of the portfolio. This risk is when markets fall sharply due to uncertain economic conditions. These tend to bounce back after a specific time period - could be months over even years.

Permanent capital loss risk - This is perhaps the most important risk associated with investing in stocks. Permanent loss risk is the possibility of losing a significant portion or all of the capital invested. Permanent losses are only possible if the investor exits the investment at a loss. For example - buying a stock and 100 and selling at 90. An investor who has bought at 100 and is sitting at the portfolio value of 90 is facing drawdowns, not permanent capital loss. The value may recover over time. An exit is important for this risk to play out.

There are other smaller risks in equity investing - but the above three remain the most relevant. So the question is, how to mitigate them?

Mitigating them requires - buying and holding stocks/mutual funds for long-periods and diversifying the investments.

Let’s understand how.

Buying and holding investments is the best way to remove drawdown and permanent loss risk. Drawdowns are temporary and giving the portfolio time to recover from short-term drawdowns is the best way to eliminate drawdown risk in the portfolio.

Permanent loss can be mitigated by diversification of the portfolio. A basket of stocks or a diversified mutual fund is a great way to avoid permanent loss of capital since the company that may go bankrupt gets mitigated by other companies that perform well.

What about volatility risk?

It can be curbed by diversification of allocation. Equity tends to be the most volatile asset class (also with the highest returns) and buying other asset classes such as bonds, gold and international equity is great to combat volatility. By adding asset classes - not only are drawdowns over a portfolio minimised, but volatility also goes down significantly. Yes, long-term returns do go down with less equity exposure - but the ability to withstand volatility makes it easier to buy and hold and hence leads to better long-term outcomes.

In conclusion, there are three key risks associated with investing in equities.

To reduce drawdown risk - look at a buy-and-hold strategy for long periods.

To reduce permanent capital loss - look to diversify by holding multiple stocks or via index funds or diversified mutual funds.

To reduce volatility - look beyond equities and add allocations to other asset classes such as real estate, bonds, international equity and gold etc.

(The writer is President – Passive Funds, Motilal Oswal Asset Management Company)