"The essence of investment management is the management of risks, not the management of returns."
"RISK": We hear this word now and then, but have you ever wondered why it's so important that every other person has a say about it? Well, it is true that throughout your investment journey, risk management can be a decisive factor in determining whether you participate in stock market folly or benefit from it. Today, in this article, we are about to explore the idea of risk management and its importance in our investment career.
Understanding Risk and Risk Management:
We are always exposed to some kind of risks, of whatsoever scale, whether it's from riding a bike, consuming unhealthy food, or simply walking down the street. From an investing point of view, we are always at risk of losing our hard-earned money in various options with the hope of generating more wealth. Even when opting for seemingly safe choices like Fixed Deposits (FDs), there is a risk of losing some or all of our money in situations like financial storms, such as the recent cooperative scandal in our country or the 2023 banking crisis in the United States. Investing, by its very nature, carries an inherent risk that is inevitable. The only feasible action we can take is to understand our level of risk exposure and minimize it to the extent possible. Therefore, risk management doesn't necessarily mean eliminating the associated risk rather it is to lower the consequences.
What Makes “Risk Management” so Crucial?
The market is a battleground where people, like us, are fighting to make the most out of their money. However, the bitter truth is that in the quest for profit, people often overlook the most important aspect of the market: survival. Prioritizing profits over survival often leads to being wiped out of the market. This is where the cruciality of risk management comes into play. Risk management may not guarantee profits, but it does guarantee survival, as the Oracle of Omaha, Warren Buffet, suggests, the first rule of investment is to: 'Never lose your money.' If you can survive in the harshest market conditions, you are most likely to perform well in favorable market conditions. Risk management safeguards your survival in the market.
Let's assume you have Rs. 1,00,000 to invest. Without proper risk management, you are likely to have only 3 to 4 chances before losing all of your money. On the other hand, with proper risk management principles, you would have enough opportunities until the market starts to turn in your favor. Therefore, in the long run, survival in the market determines your performance, and survival is possible only if you truly follow the concept of proper risk management.
How to Effectively Manage Risk?
After acknowledging the cruciality of risk management, let us now explore some of the effective ways to manage risk:
Diversification and Asset Allocation:
"Do not put all your eggs in the same basket." You might have overheard this sentence, but it is indeed true. Diversification and asset allocation are the most viable methods to manage risk. These concepts protect you from the risk of losing everything that comes from putting every single penny into the same stock or asset. That being said, don't let diversification be an excuse for your ignorance.
Navigating Risk Appetite:
To manage risk properly, you must always understand your risk appetite: the amount of risk that you are willing to take in exchange for potential gains. Set clear boundaries on your risk tolerance and always make informed investment decisions.
Accepting the Prevailing Risk:
While it may seem counterintuitive, accepting certain parts of prevailing risk is also an effective risk management strategy. You see, the uncertainty in the market can never be brought down to zero, and hence, a certain level of risk always exists. Therefore, by accepting reasonable risk, we can focus our time, effort, and resources on risks that are more critical and impactful. Remember, accepting prevailing risk does not imply negligence towards risk management; rather, it is a deliberate approach to handling risks, considering their likelihood and potential impact.
Make Informed Decisions:
Managing risk can be much easier if you always make informed decisions, as Warren Buffett quotes, "Risk comes from not knowing what you are doing." By gathering relevant information, evaluating alternatives, and considering potential consequences, you gain a better understanding of the risks involved. This allows you to reduce the possibility of negative outcomes and maximize positive ones.
The Bottom Line:
At the end of the day, what we often observe is people passionately debating about discovering the ultimate winning strategy in the market. While having a solid strategy is undoubtedly important, it's crucial to recognize that sustained success cannot be achieved without practicing proper risk management principles. When risks are handled appropriately, favorable returns naturally ensue.