In October 2020 India saw the release of SCAM 1992: The Harshad Mehta story. Literally, overnight in India, a new one-liner became the tagline: Risk hai toh Ishq hai. Completely ignoring the fact of how Harshad Mehta's life ended. In my limited understanding of the world of stocks, I have realized this: Managing Risk is probably one of the bedrock for one being successful in investment. Risk is incredibly important to long-term investors, it's also ephemeral & unmeasurable. Let's explore the R-Word.

AVOIDING RISK

Warren Buffet underperformed the market in 1999. The media wrote him off and mentioned that his style of investing doesn't work anymore. In his true Buffet style, he didn't respond. Within a year came the mother of all crashes in 2000 - the dot-com bubble burst. Warren Buffett had categorically refused to participate in the tech bubble. He was laughing then. Especially in crazy times, disciplined investors willingly take the risk of NOT taking enough risk to stand out from the herd mentality.

RISK CYCLE

The popular school of thought is "risk increases in a recession and falls in a boom". In contrast, the reverse is actually true. When there is blood on the street( read recession, market crash) and most of the investors are dominated by emotions: Fear & Uncertainty, the markets will give you some of the best opportunities. On the other end of the spectrum when there is a booming economy and most of the investors are dominated by emotions: Certainty & Optimism, and the economy appears all set for a resounding upswing, the markets are at their peak and so is the risk. Never forget this quote from Warren Buffett:

 "Be fearful when others are greedy and greedy when others are fearful."

RISK QUOTIENT

In investing, there is NO 'one size fits all approach', when it comes to allocating your capital. Portfolio construction needs to happen basis your risk quotient. If you are in your 20's, your risk-taking ability on a small-cap stock is way higher when compared to a retired professional, whose only source of income is the steady returns he gets from his FD's. But if the income of the investor in his 20's is the only source of income in his family, then even his risk-taking ability can come down, and the retired professional who has some other avenues of income, his risk-taking ability will go up, even though he is retired.

People vastly overestimate their potential to assess risk and underestimate what it takes to avoid risk. Hence people take risks unknowingly.

THE BRAKE

It was 2017 and in one of my last corporate assignments, I was hiring at IIM Ahmedabad for the Investment Banking vertical of Barclays Bank. The business head from Barclays in the presentation spoke about this analogy of how: a brake in the car, actually lets the car be driven fast. Think about it ...its indeed true. You can drive at 100km/hr because you know that you have an amazing disc brake, which will respond in a split second. Risk management in your portfolio is like the brake in a car, it appears that you are playing conservatively when you follow all the principles of risk management, but in reality, you are just enhancing the strength of your portfolio from future shocks and hence it grows.

Since 2017, the Brake analogy has stayed with me. 2017 was also the year I got interested in the world of stocks and started investing. Even today, when I get attracted to any stock, I try asking myself - What can go wrong? What are the probabilities of my assumptions not holding up? What are the external risks? I call these my " Brake Questions" and only when I am convinced with my answers to these questions I go ahead and buy a stock.

EGGS & BASKET

I am sure you would have heard this adage: Never put all your eggs in one basket. This applies to the world of stocks also. Even if you are convinced about just 1-2 stocks, it's not advisable to invest your entire money into them, efficient risk management is having a portfolio of stocks from different sectors/ industries so that even if one sector underperforms, your Portfolio is unaffected or as Nassim Nicholas Taleb says - 'Anti-Fragile'. I love the Banking & Financials sector now in 2021, India is all set to see the world's biggest financialization. But this rule of efficient risk management for my portfolio doesn't allow me to invest more than 15-20% of my capital into this sector.

The other end of this thought process is found in a quote from Warren Buffett's partner - Charlie let's explore.

"The idea of excessive diversification is madness." ~ Charlie Munger

Imagine you own 100+ stocks in your Portfolio basket, then even if 1-2 of them give you stellar returns, it will not move the needle up, for your portfolio. Having too many stocks, statistically also proves that is of no use, hence don't buy too many eggs! Err, stocks :)

It's this fine art of managing risk by Understanding Risk -> Recognizing Risk -> Controlling Risk, which will ensure your Portfolio is not only safe during crashes, but also grow with the passage of time.

Happy Investing!

P.S: Kindly do your due diligence before investing in any stocks. Seeking expert help is highly recommended.

#MadAboutStocks