The dictionary definition of risk is “the possibility of loss”. Loss in the context of equity investing could occur due to loss of capital in hand, or loss of opportunity. Given that many investors enter the market with an objective to generate quick returns, they expose themselves to risk of capital.

Emotional reactions to contemporary matters such as the US Federal Reserve rate changes, unrest in Hong Kong, etc, lead to short-term price fluctuations or volatility in markets. Volatility may be perceived as risk by someone whose objective is to make short-term trading returns. If prices fall due to an adverse reaction to news, such risks would materialise and the trader would incur losses. For long-term investors, such volatility may not be synonymous with risk and should be seen as an opportunity.

If not volatility, what is risk?

Risk may be assessed from risk of fundamentals and behavioural risk, when it comes to a long-term investor.

Risk of fundamentals: Investment is a fractional ownership in the equity business. Long-term earnings growth of the markets, in general and in business, particularly, is a key determinant of long-term stock-price movement.

The primary factors that have a bearing on this evaluation are:

1) The certainty with which the long-term economic characteristics of the business can be evaluated

2) The certainty with which the management can be evaluated, both as to its ability to realise the full potential of the business and to wisely employ its cash flows

3) The certainty with which the management can be counted on, to channel the rewards from the business to the shareholders, rather than to itself

4) Purchase price of the business

Investments in businesses with lasting competitive advantages leading to growth, where the management works to realise the full potential of businesses and channel rewards to shareholders, are likely to generate superior returns over their lifetime.

If such a business is purchased at an attractive valuation (PER/PBV/ price to cash flows), chances of superior returns are enhanced.

Behavioural risk: Investors also face risk from their own behaviour or emotions. Let us assess two such investor tendencies or biases (among many others) which inhibit investment success.

Herd behaviour – Investors’ tendency to seek validation from actions of co-investors before making investment decisions. An upward-trending stock is attractive since others are purchasing it.

In such instances, they may be buying at unattractive valuations, since the stock has already moved up.

It may be time to sell rather than buy, but herd mentality is an irresistible bias and it exposes investors to unfavourable risk.

Loss aversion – Investor’s tendency to avoid near-term losses. A loss causes greater emotional distress than the satisfaction derived from an equivalent gain.

Hence, investors exit falling stocks even if the risk of downside is limited and the opportunity is large. For instance, from a high of 21,000, BSE Sensex fell to 8,000 post the Lehman crisis in 2008.

Thereafter, over the next 10 years, it scaled a peak of 40,000 points. Many investors who experienced the downslide, lost sight of the long-term opportunity. Loss-aversion tendency took over and they exited around 8,000 levels, where downsides were limited and opportunities were high.

How can one profit from risk?

In conclusion, an investor can mitigate risk and profit from it by

1) Buying a basket of quality businesses, that annuls individual risks linked to markets, currency, business cycles,

2) Paying reasonable valuations to buy them,

3) Leveraging volatility in markets as an opportunity for equity investments with a long-term time horizon and

4) Recognising own behavioural biases and keeping them in check.

Since many investors don’t have the time or the inclination to do such an appraisal, they are best served to let professionals generate long-term risk-adjusted returns on their behalf.

The writer is head, PMS, Kotak Mahindra AMC

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