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How to understand risk in investment: 4 steps to peace of mind and profit for investors

Understanding risk is a lesson which every investor needs to learn. An investor attracts risk when he invests in stocks whose prices are above their intrinsic value.

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Understanding risk is a lesson which every investor needs to learn.

By Ramalingam K 

Understanding risk is a lesson which every investor needs to learn. An investor attracts risk when he invests in stocks whose prices are above their intrinsic value. It is a certain move towards uncertainty and the probability of incurring loss due to capital erosion is a distinct possibility.

High risk, high reward
Investors often go ahead with a supposedly high-risk investment knowing well that they are treading on a treacherous path. Sometimes such investments do fetch handsome gains. They try to make a point that their dalliance with the risk factor helped them come up trumps. For others watching from the sidelines, this move may be translated as courage and exceptional foresight, but what would happen if the investor touched a trough and lost everything instead of scaling the crest? It has to be understood that by shouldering undue risks the investor is only making his position vulnerable. Unpredictability of the future is a cardinal truth. More often than not our perception regarding the worst scenario may be surpassed and this is usually what occurs. Very few people can actually understand and predict the future correctly on a consistent basis. The ability to assess how high a stock is priced above its intrinsic value is the key to understanding risk.

Recognising risk
The natural corollary to ‘understanding risk’ is ‘recognising risk’. If people become very risk averse they will not pay heed to any warning or take cognisance of any perception of fear. It becomes a situation where “fools rush in where angels fear to tread” and they become tempted to purchase investments at high P/E multiples and wafer-thin spreads, depending on the class of asset. A financial climate which is healthy and safe will be characterised by risk aversion, skepticism, distrust, agnostic views, worry and awareness of the attitudes and behaviour of its participants.

The market cycle turns vicious as the demand for risky assets increases which in turn leads to a reduction in rates and yields. Investors who strive for greater returns in shorter periods bring more risk upon themselves. When fixed return instruments begin to offer lower yields, investors get attracted to the capital market seeking to achieve commensurate or greater returns thus raising the risk bar a few notches higher. It needs to be remembered that this is not a market in which we operate but a market which operates because of us.

Controlling risks
Loss is the consequence of taking undue risks. The transformation of ‘risk’ into ‘loss’ occurs only when a catalyst acts upon risk and coverts it onto a loss. A parasite by itself might not cause damage but when it resides inside the body of a person and acts upon it, disease is caused. Ability to control risks is what differentiates between a seasoned and a naïve investor. Positioning investments in a manner which negates or mitigates the risk element is the hallmark of a smart investor. It is very important for investors to be aware of two things which can prove to be effective safeguards against undue risk: Steps to control risk

Chart out an asset allocation based on age, risk taking propensity, and required rate of return
Identify the stocks or equity funds in which he or she is interested to invest
Make a thorough assessment of the stock, its price or valuations and its basic fundamentals
If the risks associated with the stock or equity fund in either the short term or the long term is greater than normal (based on market knowledge as far as practicable), avoid such stocks or funds and look for better options for investment.

The writer is director & chief financial planner, Holistic Investment Planners Extracted from Tax Guru

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