Why is risk management important?
Risk management has perhaps never been more important than it is now. The risks modern organizations face have grown more complex, fueled by the rapid pace of globalization. New risks are constantly emerging, often related to and generated by the now-pervasive use of digital technology. Climate change has been dubbed a “threat multiplier” by risk experts.
For a business, assessment and management of risks is the best way to prepare for eventualities that may come in the way of progress and growth. When a business evaluates its plan for handling potential threats and then develops structures to address them, it improves its odds of becoming a successful entity.
In addition, progressive risk management ensures risks of a high priority are dealt with as aggressively as possible. Moreover, the management will have the necessary information that they can use to make informed decisions and ensure that the business remains profitable. We emphasize on this subject for some reason:
- It helps to reduce uncertainty
- It is crucial for successful planning
- It helps reduce expenses and losses
- It helps improve your reputation
What are the measures for equity risk management?
You can use several equity risk management strategies. The key ones are:
- Portfolio diversification
- Using stop-losses
- Adding non-cyclicals to the portfolio
- Hedging
- Investing in dividend-paying stocks
- Pairs trading
Portfolio diversification:
Businesses are susceptible to several uncertainties that adversely affect their stock prices. To protect your portfolio from big losses, invest in multiple stocks. This ensures that even if some of your investments do not perform as expected, the others minimise their effect on the overall portfolio. While diversifying, make sure to invest in stocks that don’t have much in common. Investing in similar stocks exposes you to the same risks and defeats the purpose of diversification. For example, automobile and auto ancillary may seem like different sectors, but they are affected by similar factors. Investing in both these sectors may not help much with risk mitigation.
Remember, diversification does not mean investing equally in all sectors. It means investing in more than one asset or sector.
You can invest more in companies you are more optimistic about. But don’t commit so much that you cannot bear the losses if things go bad.
Using stop-losses:
A stop-loss order authorizes your broker to automatically sell a stock when it falls to a specific level. This protects you from excessive losses during sharp market corrections. It also checks your tendency to sit on a loss-making stock for too long in the hope that it rebounds. For example, if you bought a stock for Rs.100 with a stop-loss of Rs.90, your broker will automatically sell the stock when it falls to Rs.90. This can protect you from further losses if the stock falls below Rs.90.
Adding non-cyclicals to the portfolio:
These are stocks of companies that sell essential goods and, as such, are relatively insulated from economic cycles. Examples include pharmaceutical and Fast-Moving Consumer Goods (FMCG) stocks. Why you wonder? This is because people cannot stop spending on healthcare and groceries, irrespective of the state of the economy. At best, they may reduce their spending on some essential goods and services. As such, non-cyclical stocks have relatively stable revenues, which translate into stable stock prices. You may find many experts call them ‘Defensives’.
Hedging:
Hedging refers to the use of derivative instruments, such as Futures and Options contracts, for risk management in equity. A futures contract helps you to fix the price for a future buy/sell transaction in the future. This way, you can cut down the risk of price fluctuations. For example, even if the price of your stock falls, you can sell it at the higher price that you fixed. Similarly, you can buy at lower rates even if the price rises thanks to derivatives contracts. There are different types of such derivatives contracts that you can use. We’ll read about these in depth in the Derivatives section.
Investing in dividend-paying stocks
Companies that have a history of consistent dividend payments are usually strong, established companies. Adding them to your portfolio can shield you from equity risk.
Companies are generally reluctant to cut their dividends because the market perceives a dividend cut as a sign of poor financial health. As such, dividend-paying stocks also ensure that you receive a constant stream of returns, even if their prices fall. They reduce risk by bringing more predictability and stability to your portfolio.
Pairs trading:
This is a good way to mitigate equity risk when you are anticipating a big price move, but are not sure of its direction. An example is when a big regulatory decision is expected to be made, but you don’t know what the decision will be. In such cases, you simultaneously buy the stock of one company and short sell (i.e. sell first and cover by buying later) the stocks of another company from the same sector. Ensure that both stocks are not related and are likely to benefit in different ways. This ensures that irrespective of which stock rises or falls, you profit. We’ll look into this in detail in the Technical Analysis section.
At the end of this article, It is true that stocks are risky investments because their price movements can be volatile and unexpected. However, there are several risk management tools in equity markets that you can use to mitigate your losses. These tools help you enjoy the high returns that equities offer, without having to necessarily endure the high equity risk.
