Assessing portfolio risk holds the key

The influx of hyper liquidity has set off a revenge trade on the bourses across the world. The equity markets in some countries have almost recovered from the lows of the initial panic trade in March of this year, while in most countries, the losses were reduced by a huge margin.

This is completely bereft of any rational especially when compared to the economic situations across the nations which are slowly beginning to opening up from their lockdowns & closures.

Though, the economic reality is far from rosy and an uncertain immediate to medium-term future, stock markets have turned optimistic of recovery.

At these volatile times, it's important to tread investing in equities with caution, while equally trying to grab the opportunities by participating in the markets.

They say that markets don't provide returns, but it's we, investor ourselves, who would… While there are multiple ways or styles of approach to investing in stocks, some of these principles could be handy.

Especially, these inputs are from the risk point of view as I personally believe returns are an outcome of risk management. When we invest in a particular stock(s), we take into account the current cash at disposal, the future possibilities for that stock, our timelines and expectations of gains/returns from that stock(s).

Also, we consider a certain amount or portion of our capacity to invest in a stock, or in case a portfolio of stocks, there is a proportion of allocation to each of the stocks, the reason being one or all of the above mentioned.

Diversification: 'Don't park all eggs in one basket', etc., may sound clichéd, but has a profound meaning. Concentration could derive best of the returns when the market approves of our picks, but could turn grave when not in favor.

Higher risk appetite alone wouldn't be sufficient to overcome concentration risk and diversification of stocks is an answer. Usually, diversification is done by creating a portfolio of stocks so as to mitigate risk and thus enhance the risk to reward ratio.

The best way to add the ingredients is to have a set of non-correlated instruments in a portfolio. The contrarian pie of the portfolio insulates from volatile market situations and helps tide over at various market situations, most of the times.

At the beginning while investing in stocks, most of us aim to hold for long time say 5, 10, 15 years and even higher, thanks to our nascent enthusiasm. But in reality, we find unease at the very first instance of the volatility.

It makes us to either rue to the fact that we couldn't profit book part of the of the performing stock/portfolio before the drawdown or beat ourselves for not topping up more of a stock currently on an upswing during its movement downwards. This could be avoided by keeping a journal on why a particular allocation is done for each stock.

This enables us to unnecessarily increase the risk just by allowing into increase to a proportion which one is not comfortable with either by the virtue of it going up significantly in price or taking a higher allocation when trying to average the price.

Portfolio sizing: Remember the first principle of investing is not losing money and a higher concentration of a single stock could've a catastrophic loss. Then the mental trauma of the loss in your favorite stock is more painful than the actual loss.

At times we resort to averaging out of a falling stock merely to reduce the cost of acquisition throwing the risk mitigation to wind. Unknowingly, one might end up with concentration risk with too much exposure to a stock while trying to average out. One needs to define what amount/size (percentage) of total portfolio is in a particular stock, at the start itself.

We tend to retain the stock as it outperforms the other in the portfolio and even at times increase the exposure. I don't find it completely wrong, but while doing one should've an eye on the risk to the portfolio also.

For example, if a stock X is considered to have a comfort zone of five per cent allocation in your portfolio, even if this stock outperforms relative to the portfolio and bloats to a higher proportion then one needs to shave off the additional exposure. If it requires selling a portion of the holdings, so be it. Ignoring this rule would only amplify the trouble when the performance is reversed.

Similarly, when there is a correction in the price of a stock, one needn't rush to employ further capital to average the stock. They could use the same methodology to draw a limit of exposure for any stock within the portfolio.

Thus, by having a bandwidth of exposure defined to every stock in the portfolio, one could be aware of the risk being taken. One would appreciate this exercise only in times of market strife and it would heed good advice.

So, when investing in stocks one needs to have lower and upper bands of allocation limits for each stock and should be followed religiously. One shouldn't get carried away by the markets in either averaging or topping up further than the limits irrespective of the performance.

Thus, one could assess well about the risk associated with the portfolio and avoid undue risk.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)