The risk of Equity Investments

The risk of Equity Investments

My previous post was about the risks involving debt investments  ,in which we discussed issues around credit and interest rate risks . Now its time to extend this to equity investments. 

What is equity 

Equity , in terms of investments is buying ownership in a business. The investor becomes a full participant in the gains or losses the business makes , unlike debt where the investor is looking for a "certain" cash flow. 

Equity returns

Equity returns are mainly from two sources 

• Price return - If you are able to buy a stock for 100 INR and sell it for 120 INR , you make a 20 INR price return. So follows the commonly used term, buy low, sell higher.  What is important to understand is that you do not realise (i.e. encash) your profits here unless you sell off the share in the trading market. Until then the profit/ loss is a paper profit/loss. 
• Dividends - Sometimes companies return a part of their profit to their shareholders in form of a periodic payments called dividends. This is not a certain payment , though some companies maintain a stable dividend payment ratio. Also to remember here is that some high growth companies who think that their capital is better utilized in new opportunities , do prefer to do so and not pay any dividend. So it can also be said that sometimes dividend paying companies may not be a high growth company. Typically income investors invest in dividend paying stocks. 

Equity investment returns are therefore inherently uncertain , and this uncertainty is a feature rather than a bug. This writeup is all about getting a high level understanding of the uncertainties or risks facing equity investments. 

What is Risk

As mentioned earlier, risk is not a negative term. In financial markets , excess returns can only be generated by taking on risk. Risks can sometimes be avoided or mitigated (at a cost), otherwise one can also choose to take on some kinds of risk

An investor needs to understand the type and quantum of risk that are inherent in her portfolio and ensure that she is comfortable with it. Prudent risk taking is a great way to build wealth over long term

Understanding the types of risk

What i will try to introduce here is a simple framework. (Noble prizes had been won on this area and there is a vast amount of academic work done on this , but my aim is to make it simple for the regular investor and so i will not cover complex topics like the 5 factor model )

When you invest in Equity of a specific company , you are generally exposed to two different kinds of risk 

• Risks Specific to the company - E.g. say for a pharma stock, a clinical trial fail/succeed , or for a logistic firm if a warehouse catches fire or a CEO quits suddenly etc. In finance , we call this idiosyncratic risk
• Broader market related - Issues that affect the overall market , e.g. Ukraine crisis (as i write this), the COVID 19 crisis etc., inflation fears etc. These issues affects your stock , even if its doing well on its own.  We call this systematic risk

The Portfolio Context 

Investment risk is always measured in a portfolio context and the risk borne by a standalone asset is not the correct metric for risk management.  In a portfolio context , risk is not additive and this is perhaps the most important point in here. 

e.g. say you hold a portfolio of nifty50 ETF and gold equally - is the overall risk of this portfolio sum of the risks in the ETF and gold ? No its lesser. Why ? because often when markets crash in fear of something bad , people turn to gold and its value increases. So in a portfolio context the two assets reduce the risk of each other vs their standalone risk

This brings me to the point of diversification 

Diversification - a free lunch ? 

The earlier example of a gold and Nifty portfolio is a simple example of diversification. We have often heard the saying that do not put all your eggs in the same basket , and this is nothing different.

Remember the idiosyncratic risk , mentioned earlier - this can be largely avoided just by diversification 

Is it a free lunch , it can be argued either ways . When you diversify , you may loose the chance of exposing yourself more to a "multibagger" , which you can say is the cost of diversification. But i will argue that its a risk management technique. 

If your style of investing is to identify multibaggers and run a very concentrated portfolio , then there is nothing wrong , given you fully understand that you are taking on lots of idiosyncratic risk , which can go either way (in addition to the systematic risk, which is also in there)

Another style could be running a diversified portfolio of a basket of securities , where you expose yourself only to the systematic risk , and expect a return accordingly. You may gain less from multibaggers , but this also reduces the chances of a dramatic drawdown. 

If you are an investor and not a gambler, chances are that you will prioritize proper risk management over wild returns that can go either way.

Naive diversification

Say you have a 3 stock portfolio, see the 2 portfolios below

1. 33% HDFC bank , 33% Kotak bank , 33% ICICI bank
2. 33%  TCS , 33% HDFC Bank , 33% ITC 

Which of the 2 portfolios do you think is better diversified ? Chances are its the second one. 

Although both have 3 stocks each the first portfolio holds 3 stocks of similar companies (i.e. large private banks) , vs the second one is a bit better split into IT , Banks and Consumer staples. 

The point that i am trying to make is simply buying different stocks is not really diversifying well. There are a lot of interesting ways to do this including complex quantitative modelling of correlation of risk factors etc.. but there are simple solutions available. Simple broad market index ETFs (e.g. a Nifty or Sensex ETF , or a S&P 100 ETF) do a reasonable job of achieving prudent diversification of portfolio. 

Also remember - this diversification also applies to several other ways as well e.g. 

• By geography ( the US market is more than 50% share of global stock markets , India is circa 2% )
• By market capitalization i.e. large cap vs mid cap vs small cap
• Industry , as explained in the example above , sectors react differently to commodity prices and policy changes . 
• Growth vs Value stocks or momentum vs mean reverting stocks (this is for a different day) 

But all of these can be simply achieved by passive means of asset allocation and does not really require one to be a quantitative modelling expert like Jim Simons , or a stock picker like Warren Buffett.

Ultimately for any long term investor an allocation to equity is by far one of the best ways to beat inflation . Generally the problem is with wrong expectations, its the aim to get rich quick by running concentrated portfolios that has a higher chance of ruin , this is where one can avoid dramatic consequences by proper risk management