11.3 Risks in stock investments
STOCK INVESTMENTS & RISK
Risk and reward are the two sides of the same coin. So the best strategy of investment is to minimize the risk and maximize the profit. So let us discuss some of the risks involved in stock investments and strategies to overcome the same.
Investment Risk 1: Business Risk:
Business risk is, perhaps, the most familiar and easily understood. It is the potential for loss of value through competition, mismanagement, and financial insolvency. There are a number of industries that are predisposed to higher levels of business risk (think airlines, railroads, steel, etc). For example, some of the low cost airlines, due to the skyrocketing oil prices, could not withstand the competition.
Investment Risk 2: Valuation Risk:
Now you may find a company you like. The margins are excellent, growth is steady, there is little or no debt on the balance sheet and the brand is expanding into a number of new markets. However, the business is trading at a price that is far in excess of its current and average earnings. It is therefore not possible to justify purchasing the stock. Here it is not the business risk but the valuation risk. This is the risk of investing in overvalued companies. So you need to rephrase the question before investing. "Is company ABC a good Investment?" The answer may be 'yes'. But then ask, "Is company ABC a good investment at this price?"
Investment Risk 3: Force of Sale Risk (Liquidity):
You have done everything right and found an excellent company that is selling far below what it is really worth. It’s January and you plan on using the stock to pay your or your child's college fees in June. By putting yourself in this position you have bet on when your stock is going to appreciate. This is financially a fatal mistake. The stock market can be relatively certain of what will happen, but not when. For example, take the case of the stock prices of Satyam Computers which tumbled down. Mr. A and Mr. B brought 1,000 shares at the rate of Rs40 per share. But Mr. A had used the money which he had reserved for another important use in the coming few days. The next day the share price of Satyam Computers fell to Rs13 and even though both of them knew that it was going to recover from this slump Mr. A could not capitalize on the market. But Mr. B could afford to remain in the market. In a month’s time, Satyam Computer’s stock jumped to Rs59 and Mr. B could make a neat profit.
Manage Your Risk:
As an investor you are always forewarned to judiciously single out stocks based on strong fundamentals. Yet, people make mistakes by purchasing stocks that are referred to as hot picks or gainers by word of mouth or through sources on the internet. However, understand the fact the time lag between the discovery of these value picks and the purchase often factors in whatever arbitrage is available. Consequently, an uninformed investor buys into a stock at its peak and is disappointed on its decline thereafter. However, if one is well convinced regarding the fundamentals and long-term performance of the stock, one mustn't get swayed by price fluctuations. A strategy to make good gains from such price volatility is referred to as ‘pyramiding’ as in SIP (discussed below).
For most investors, it is less risky to invest smaller amounts of money, and add to the investments on a regular basis over time. That's called 'rupee-cost averaging' and in general it results in lower cost of investments and higher returns. Let us assume that an investor is convinced about a stock’s long-term prospects and upward trend. In such a situation, every price drop should be mediated as an opportunity to buy into the stock. This will lower the average price of the stock and will consequently imply higher gains for the investor on price recovery. Another strategy is to cumulate additional stocks on every rise. Although this increases the average holding cost of the share, it collates greater holdings at an average price if one is confident about the long-term average trend. This concept emulates the concept wherein more funds are committed from an asset class like debt to equity when the long-term prospects of equity seem positive.