Learn why risk management is important and create a portfolio based on it for a long-term financial discipline when investing in equity.
Investing in the stock market may offer lucrative returns. While those returns may be attractive in the long term, there are inherent risks due to market fluctuations and other unexpected events. Such factors can significantly affect the outcome of the returns.
A certain degree of volatility and uncertainty is unavoidable in the stock market, but a well-planned risk management strategy can be a way out. It acts as a foundational element that helps you protect your capital, maintain consistency, and stay aligned with long-term financial goals.
Risk, in this context, refers to the possibility that actual returns may differ from the expected outcomes. It doesn’t always imply a loss, but refers to any uncertainty in performance.
Low-risk investors often prefer low-risk options, seeing them as more attractive. However, the general outlook is that higher risk usually brings higher returns in the long run.
Types of Investment Risks
As an investor, you can face various risks that can impact your returns and financial goals. Understanding these risks helps you make a well-thought-out decision to manage your funds. The table below explains the different types of investment risks:
Type of Risk |
Details |
---|---|
Market Risk |
Market fluctuations may cause losses, including equity, interest rate, and currency risks |
Liquidity Risk |
You may struggle to sell assets quickly without losing their value |
Concentration Risk |
Investing too much in one asset or sector may increase potential losses |
Credit Risk |
Bond issuers may fail to pay interest or principal on time |
Reinvestment Risk |
You may have to reinvest returns at lower interest rates |
Inflation Risk |
Rising prices may reduce your purchasing power |
Horizon Risk |
You may need to sell investments earlier than planned, possibly at a loss |
Foreign Investment Risk |
International political and economic changes can impact your foreign investments |
Say you are self-employed or a freelancer. You have a high risk appetite, and your investment portfolio consists of the following:
Large and mid-cap stocks
Equity mutual funds
Corporate bonds
ELSS funds
Given the nature of your earnings, there exists a horizon risk due to unsteady income. There is also liquidity risk, as you won’t be able to withdraw ELSS mutual funds in the first three years. Consider all these factors to balance your portfolio and choose the ideal investments.
Manage your expectations after a thorough market study and considering all the possible risks. Here’s why risk management matters:
Capital Preservation
The primary goal of risk management is to protect your capital. If capital is lost due to high risk exposure, the ability to recover and grow wealth reduces.
Consistency
Risk-managed portfolios are generally more stable. They reduce extreme fluctuations and encourage staying invested during market turbulence.
Better Alignment with Financial Goals
Managing risk ensures that your investment strategy remains aligned with your financial goals, time horizon, and life stage.
Reduced Emotional Decision-Making
Setting limits for yourself, like how much to invest in different assets or when to cut losses, helps you stay calm during market drops. It will also help you to avoid getting carried away when things go up.
Several techniques are available for risk management, and their use depends on personal risk tolerance, goals, and market conditions. Check them out below:
Diversification
Spreading investments across asset classes (equity, debt) and sectors (IT, FMCG, etc.) helps reduce the impact of underperformance in any one area.
Example: Holding stocks in different sectors can help when one sector (e.g. EV) underperforms while another (e.g. banking) does well.
Asset Allocation
Asset allocation involves dividing your investment portfolio among various asset categories based on your financial objectives and risk tolerance.
Sample Allocation Based on Risk Profile:
Risk Profile |
Equity |
Debt |
Others (Gold/REITs) |
---|---|---|---|
Conservative |
30% |
60% |
10% |
Moderate |
50% |
40% |
10% |
Aggressive |
70% |
20% |
10% |
Position Sizing
This refers to determining how much capital to allocate to a single stock or investment.
Formula:
Ideal Position Size = Account Risk Limit/Amount of Trade Risk
Use of Stop-Loss Orders
Stop-losses are price levels set in advance to exit a stock automatically if it falls beyond a certain limit. While this does not guarantee complete loss avoidance, it helps limit damage.
Portfolio Rebalancing
Periodically reviewing and realigning your investments to your intended asset allocation helps maintain risk levels.
Example: If equity outperforms and your portfolio shifts from 50:50 (equity:debt) to 70:30, rebalancing brings it back to target.
Hedging
Dollar-Cost Averaging
Investing in Blue-Chip Stocks
Risk management is not a one-time activity. It is a continuous process that evolves in response to market conditions and personal circumstances. Here are some tips to incorporate these strategies into your portfolio:
Assessing Personal Risk Tolerance
Risk tolerance varies from person to person. Key influencing factors include:
Age
Income stability
Financial obligations
Investment horizon
Setting Realistic Expectations
Chasing unusually high returns without understanding the accompanying risk can be demotivating if you face a loss. Building expectations based on past averages and rational forecasts is key.
Continuous Learning and Review
The market evolves constantly. Risk management practices should be updated periodically to reflect new risks, tools, and financial products.
Risk is an inherent part of investing, and incorporating a structured risk management approach can help maintain the health of your portfolio. By consistently applying principles such as diversification, asset allocation, stop-loss mechanisms, and realistic goal setting, you can navigate market uncertainties with more confidence.
This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.
Sources:
https://investor.sebi.gov.in/securities-risks_trade_derivatives.html
https://economictimes.indiatimes.com/mf/analysis/asset-allocation-the-single-most-important-financial-decision-of-your-life/articleshow/116961275.cms?utm_source=chatgpt.com&from=mdr
https://www.businessworld.in/article/managing-risk-a-crucial-aspect-of-stock-market-investing-512149
https://timesofindia.indiatimes.com/blogs/voices/why-it-is-important-of-risk-management-in-stock-market-investing-mitigating-volatility-and-uncertainty/
https://economictimes.indiatimes.com/markets/stocks/news/what-is-a-common-success-mantra-of-stock-traders-zerodhas-nithin-kamaths-take/articleshow/119118839.cms?from=mdr
https://economictimes.indiatimes.com/markets/stocks/news/learn-with-etmarkets-a-complete-guide-to-risk-management-in-stock-investing/articleshow/105161904.cms?from=mdr
It refers to the process of identifying, analysing, and taking steps to mitigate potential losses in stock investments.
Diversification reduces the impact of a single stock or sector's poor performance by spreading investments across different areas.
Yes. Beginners are especially vulnerable to market volatility and behavioural biases. Risk management protects capital and instils discipline.
It distributes investments across asset classes based on individual risk tolerance and financial goals, thereby balancing risk and reward.
No, risk is inherent in the stock market, and you cannot eliminate it. By understanding it, you can use strategies to minimise it.